Current Interest Rates are Low – What does that mean??

It means that the return you will get on a newly purchased bond will be low and locked in at the rate for the duration of the bond,

  • Which means that, with a mature staggered bond portfolio, typically only one tenth of your bond portfolio will mature in a given year, giving up its old, higher rate of return in exchange for the afore-mentioned low rate on the replacement bond
  • In turn, the other nine tenths of your bond portfolio will continue to earn the same long term yield
  • Which means that the average yield to maturity of your whole bond portfolio isn’t affected much by the one tenth that matured in the year
We have improved your Annual Report information this year to show you this impact by comparing last year’s average yield with this year’s. In example portfolios, the drop is typically less than one tenth of 1%.

It means that we have been adjusting our strategy somewhat this year in response to the low interest environment. If a bond matures in your portfolio this year, we assess whether your asset allocation strategy calls for the matured bond proceeds to return to your bond portfolio, or shift to equities.

  • If it is called back to bonds, we consider:
    • Acquiring a new bond that falls out at the bottom of your bond ladder
    • Acquiring a new bond that might in-fill within your bond ladder to a shorter maturity, giving it fewer years of a low return
    • Acquiring a different kind of fixed income security. This might include:
      • A bond mutual fund, like TD Canadian Bond Fund
      • An ETF corporate bond fund, like “XCB”, that has some corporate holdings, which provides a higher return in exchange for diversified risk across many corporate holdings
      • A real-return ETF (“TIPs”), which is a security which hedges future inflation, as the return on the bond portfolio is tied to future inflation experience
      • A bank preferred stock, which has a high yield and tax-favoured dividend tax credits
      • A Preferred ETF (“CPD”), which holds a diversified basket of said stocks

In contemplating all of these choices, we bear in mind the impact on the diversification of strategy in your overall bond portfolio. Remember that the inner mind-game of investor psychology is so important to portfolio management and sound sleep. If one buys into the strategy of a staggered bond portfolio, then, over time, there will be occasions where a low-paying bond finally matures (yeah!) and happens to be replaced in a high interest-paying environment…and we are happy. The flip-side is what we have now…where the reinvestment environment is low. While it is the nature of behavioural investing to treat good news and bad news asymmetrically, we need to harken to John Maynard Keynes’ dictum of facing such moments with “equanimity and without reproach”.

It means that future interest rates may rise,

  • Which means that maturing bonds you replace in the future will reward you with higher rates
  • And also means that all your present bond positions will drop in price on your monthly brokerage statements, causing the current return for the year to decrease from the locked-in return to maturity

However, you need not concern yourself with the month-to-month price fluctuations in your bond holdings, knowing that the payout at maturity and yield-to-maturity is secure and known.

Your Annual Report shows your average yield-to-maturity this year, the comparative average yield last year and your one year return.

Where your bond allocation is a high percentage in your asset allocation strategy, your overall portfolio return for that year will take a hit,

  • Which means that either your equity allocation must perform well to compensate or else your overall portfolio return will indeed be poor that year

This is indeed what happened through May/June 2013. Consider the following table of data on recent bond returns in sample portfolios:

The one-year current yields dropped quickly and precipitously after April 30th. However, for the May and June examples, the equity component of the portfolios averaged, very roughly, 16%, producing a satisfactory year of overall portfolio returns.

The investing world is extremely complex, with multiple currents colliding, or sometimes colluding, over time to offset, or sometimes amplify, each other in producing the portfolio returns delivered to investors. So, once again, you need to seek Keynes’ equanimity from a, hopefully, satisfactory long term compound return over your investing life.

We report and graph this long term compound return statistic annually in your Annual Report. The longer you have been with us, the longer the reporting compound period… and the longer the compound period, the more relevant it is to you in assessing your financial fitness.

Lastly, remember the sports analogy of authors Stanley and Danko (“The Millionaire Next Door”). Your financial fitness is the result of both your offence (making money) and your defense (spending money). Very few championship sports teams attain greatness with one but not the other!

Article Published 10-Sep-13