Fixed Income:
Should we worry about rising interest rates?
Fixed income securities like bonds are usually considered to be less risky than stocks. But bond prices fluctuate in the market just like any other security. Prevailing interest rates are what determine their price in the secondary market where bonds are traded.
There are several types of risk that apply specifically to bonds. In a post-financial-crisis world, terms like credit risk, liquidity risk and interest rate risk are used constantly. So it’s not surprising they’ve taken centre stage in investment talk forums.
We portfolio managers watch interest rates changes very closely. They can go up and down quickly and cause price fluctuations that affect the overall returns of fixed income securities. The prospect of interest rate risk, in which rising yields trigger price losses for investors, is always near the top of our radar screens.
Despite today’s monetary policy and the odd comment from the Bank of Canada about maintaining the status quo, it’s expected that interest rates will rise in the not-too-distant future. Some of the most telling indicators are:
- Moderate strengthening of the U.S. economy;
- Improving employment conditions;
- Prevailing interest rates remaining at near-historic lows;
- Shifting outlook about this period of unprecedented monetary accommodation, which has made money cheap to borrow for a long, long time; and
- Investors' demand for higher yields from companies wanting to sell new bonds.
When yields change, bond prices change, too. Interest rate risk does not affect all bonds equally. The amount of fluctuation that interest rates can produce in the price of a bond depends on both its term to maturity and its coupon rate. The price differential will be larger when the coupon interest is lower and the time horizon to maturity is longer.
Example:
The table below illustrates the percentage change in bond prices over a one-, three-, and five-year term to maturity following a rate increase of 2%.
| 1 year | 3 year | 5 year | |
|---|---|---|---|
| 4% Coupon Rate | |||
| Current price 2% | 101.97 | 105.80 | 109.47 |
| +2% 4% | 100.00 | 100.00 | 100.00 |
| % change in price | -1.93% | -5.48% | -8.65% |
In our view, the risk regarding interest rates is to the upside. As a strategic response, WDS has shortened maturities to help buffer against interest rate risk and preserve capital. When they’re available, we add quality corporate credits to enhance yield.
At least for the time being, high-interest savings accounts provide comparable rates with easy access to funds and no risk to capital. The “give-up” in yield is relatively small when interest rates are so artificially low.
For more information, see GetSmarterAboutMoney.ca Understanding the risks, which describes the four common risks for bond investors.
RESULTS
at a glance
Before the ink dried on this edition, another political blunder—this time, the Cyprus deposit tax plan—disrupted global markets and sent investors scrambling yet again. In its simplest terms, the initial plan would impose a tax on depositors’ bank savings. Imagine?!!! The aftermath has not erased stock market gains to date but once more, it’s dampened investors’ enthusiasm for risk-taking. Good news for gold and the U.S. dollar, though, both of which rose on their “safe-haven” appeal.
We welcome the start to Q1/13 with the S&P/TSX Composite Index* at 12,800, up 3.3 per cent. South of the border, the U.S. S&P 500** continues to outpace the last several years’ performance on its strengthening economic factors—9.2 per cent higher at 1,563.
The Bank of Canada left the overnight interest rate unchanged on March 6, 2013. Longer-term bond prices fell slightly as interest rates rose. The yield on the 10-year Canada benchmark for bonds is 1.95 per cent, while the yield on the U.S. 10-year benchmark is now 2.03 per cent.
The Canadian dollar has weakened against the U.S. dollar, closing below parity at $0.9794 per USD. Renewed demand for U.S. equities has been positive for the greenback.
In the energy sector, crude oil climbed to U.S. $93.03/bbl (1.49%). Gold bullion fell $82 (-4.79%) and is now trading at U.S. $1,590.
*Returns based simply on price appreciation (dividends are excluded).
**Foreign equity indices based in USD.
Data as of March 14, 2013. Source: TD Weekly Insights as of March 15, 2013.
We believe Treasuries have gone from offering “risk-free returns” to now effectively becoming “return-free risk.
– The Core Conundrum, Section 2 Coping with New Market Realities
Guggenheim Partners, Portfolio Strategy Research, February 2013
ASK & ANSWER
When should you take a capital loss on a bond?
ASK
I bought a $10,000 face-value bond at a premium, paying 105 per cent or $10,500. The coupon interest rate is 5 per cent. My all-in cost was $10,625, including the accrued interest paid. When the bond matured, I received the face value of $10,000. Can I claim the $625 as a capital loss for income tax purposes?
ANSWER
The coupon interest rate of 5 per cent means you receive $500 of interest income each year, whether you buy the bond at face value, a premium, or a discount. The $125 accrued interest that you paid on the purchase is deducted from the first $250-interest installment you get.
Bonds trade at a premium when prevailing interest rates are lower than the coupon interest rate. A premium bond will continuously decrease in price until it reaches face value at maturity. This is the reason a bond purchased at a premium pays a lower yield than its stated coupon rate.
In “tax-speak”, a capital loss is the difference between what you receive for the bond and the adjusted cost base (“ACB”) of the bond you purchased. So, that $500 premium amount that you paid, over-and-above the face value of the bond, will be a capital loss when the bond matured.
Dispositions and redemptions of bonds appear on the TRADING SUMMARY – 2012 T5008 / RL18 issued with your annual T5 Statement of Investment Income. Be sure to complete Schedule 3 and attach it to your tax return in order to report capital gains or capital losses on the disposition of bonds and other similar properties.
WDS READS
ENDGAME: The End of the Debt Supercycle and How It Changes Everything
John Mauldin and Jonathan Tepper, John Wiley & Sons, Inc., March 2011
The last 60 years have created a global debt supercycle, which caused a huge bubble in asset prices around the world. When the last one finally popped—as bubbles always do—it marked the beginning of what’s now being called The Great Recession. During the last five years, massive amounts of private household debt shifted to the government. That debt has not melted away, and neither have the “fingers of instability” that remain in its wake. Now it’s the governments of the world that have debt problems and are fast approaching the limits of their ability to borrow money.
Endgame lays out country-by-country scenarios of what's required to bring debt back to manageable levels. The book helps the average reader, like me, grasp the hard reality of the choices we’re facing. The entire developed world cannot simply “grow its way out of debt” any longer. The rules of economics will not work that way.
If you enjoy the book as much as I did, you may want to subscribe to author John Mauldin’s weekly e-newsletter, Thoughts From The Frontlines. I’ve become a regular reader, and recommend it.
"We all know we have seen the end of an era, and now we have courtside seats to watch the Endgame unfold. We are watching the end of Act I: The Debt Supercycle. Now we will get to see how Act II: The Endgame plays out."
—From Chapter 1, page 4
Greece isn't the only country drowning in debt. The debt supercycle—a situation in which easily managed, decades-long growth of debt results in a massive sovereign debt and credit crisis—is affecting developed countries around the world, including the United States. For these countries, there are only two options, and neither is good. Either restructure the debt, or reduce it through austerity measures.
Endgame details the debt supercycle and the sovereign debt crisis and shows us that, while there may be no good alternatives, the worst choice is to ignore the deleveraging that resulted from the debt crisis.
Praise for Endgame
"This is an extremely powerful, sobering, well written and highly accessible book. It will demonstrate to you why there are no painless solutions to the mounting debt problems around the world—something that too many people are yet to realize. It will take you on a well-documented journey thought the debt super cycle, making stops around the world and at critical junctures. And it is a must-read for anyone wishing to understand the global debt dynamics and ways to protect against its bad consequences."
– Mohamed A. El-Erian, CEO, PIMCO; author of When Markets Collide
Book Review: Endgame - The End of the Debt Supercycle and How It Changes Everything – Seeking Alpha
Gather up slips and track that list!
The very first step for making sure you file a complete income tax return is to gather up all of your tax slips ("T-slips"). Your investment income—interest, dividends, trust distributions, etc.—are reported on various (and often multiple) T-slips, issued at different times. The T5 slips are out by February 28th. But T3s aren't due until March 31st, so they're responsible for most taxpayer slip-ups.
To eliminate the guesswork, TD Waterhouse includes a PENDING TRUST UNIT SUMMARY list each time its computers issue a batch of T3s. This page gives a listing of trust-unit holdings that haven't been reported in time to be included on that particular run date. It's a handy tool you can take to your tax preparer so you both can keep track of what slips are still outstanding.
Canada Revenue Agency aggressively reassesses for missing T-slips, so don't become a casualty of CRA tax penalties if you can possibly help it. If you're uncertain about what you've got and what you need, don't hesitate to ask your investment adviser.
You've heard the terms "bull" and "bear" bandied about in the investing world. You probably know they're associated with rising or falling markets. But just how these words worked their way into the language to mean something other than big scary animals with hooves and claws is an interesting story.
The use of "bull" and "bear" to describe features of the stock market actually originated with two related families in the U.K.: the Bulteels and the Barings. Edward Baring was a British banker who married Georgiana Bulteel of Fleet, joining the "Bars" with the "Buls". The Barings' bank had a crisis during the Panic of 1890, which destroyed their family wealth.
The animal imagery comes from a pair of large stone gate piers. They are surmounted by a large bear and sitting bull holding shields, which stood at the boundary between their two estates.
FRIENDS, FAMILY MEMBERS AND WDS
Before suggesting that a friend call us, we're often asked, "Are you accepting new clients?" Thank you for that courtesy. We're firm believers that good people always know other good people, and so, yes! We welcome your introductions to people like you.
When you spot a need for advice that we might help fill, have your friend or family member come talk to us. We want to help.
We thank you for your support and appreciate all your referrals. Your confidence means everything to us, and we'll work hard to justify it.
PLEASE NOTE: The information presented in this e-newsletter is of a general nature only and does not give advice on any particular matter. It is not intended to replace personal, professional advice based on individual circumstances.