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 The
Money Management Newsletter: GICs
and Fixed Income
Taking a look at Income-Generating Investments
in a Rising Interest Rate Environment
By The Money Management Editor
Money Management Newsletter - January 2005
Income-generating investments are used to provide exposure
to a variety of securities, as well as deliver income. In other words,
an alternative to using only traditional GICs or bond funds to receive
income. With interest rates at low levels many investors and some experts
seem to agree that a period of moderately rising interest rates is not
far off the horizon. Often the belief held is that income-generating investments
such as bonds will be negatively impacted when interest rates start to
rise. Here is something to consider.
The primary role of income-generating securities in
most diversified portfolios is to reduce volatility through a low correlation
to other investments. They also help generate an additional income stream,
through frequent distributions, for investors wishing to supplement their
current household income. However for investors who only want a portfolio
of income producing investments, emphasis should be placed on diversifying
the portfolio risk and broadening the income mandate by allocating funds
to asset classes, such as dividend-paying equities, income trusts, preferred
shares, high yield bonds and convertible debentures. The diversification
benefits within these portfolios help reduce the impact of rising interest
rates by adding securities that will react differently to interest rate
movement. We examine some of them below.
The role of bonds in a well-diversified portfolio is
clear - they reduce the volatility of a portfolio. The inverse relationship
between bonds and interest rates can be simplified to say that the value
of a bond will increase when rates fall and decrease when rates rise.
However, one must always remember that bonds pay out coupon income, which
means that the loss on the value of a bond during rising interest rates
is always cushioned by its coupon. Interest rate increases must be substantive
in a short period of time to diminish the marginal effect of the coupon
on the actual bond valuation. As well most portfolio managers will actively
manage the bond terms within their portfolios, increasing or decreasing
the average term to adjust to expected changes in interest rates.
While high-yield bonds may be categorized as bonds,
these investments can play a significant role in an investor's portfolio,
not just because of their higher coupon but also as a strategic element
of diversification. For example, in the U.S. market, investment grade,
corporate bonds have had a high correlation to U.S. Treasuries while lower
grade, high-yield bonds, have been much more closely correlated to U.S.
Equities. This is because the higher yield on the bond is related to the
less desirable financial characteristics of the issuing company as well
as the prevailing interest rate environment. Therefore investors who purchase
these higher risk bonds are much more attuned to any changes in the direction
of the stock market that will impact the financial outlook of the bond
issuer. As such the bond prices will fluctuate with stock market changes
as well as prevailing interest rate movements.
Convertible Debentures express no correlation with investment
grade bonds, preferred shares and/or income trusts and have a very low
correlation with high yield bonds. This is due to the debenture's lack
of sensitivity to interest rates. A convertible bond is made up of two
components, a straight bond plus a call option. If interest rates rise,
it impacts the straight bond, but helps the call option because higher
rates means higher option valuations. And if rates rise in response to
a positive economy and higher stock markets, this further helps the call
option. So this would be the only fixed income sub asset class that is
the most sensitive to stock markets, but at less risk.
Dividend-paying securities and income trusts add additional
layers of diversification to the portfolios. The valuations of these asset
classes are dependent on the types of businesses represented. Income trusts
are high yield equities whose underlying businesses flow through distributable
cash-flow in a tax-efficient manner. Their sensitivity to interest rates
will vary depending on the type of trust with utility and real estate
trusts more sensitive than business and resource trusts. Dividend-paying
securities are appealing because of the dependable income stream they
can provide. In a rising rate environment, often coupled with favourable
economic conditions, many industries and in turn individual companies
will benefit and thus the share value will rise. Similar to bond coupons,
dividends act as a cushion against stock market losses.
Preferred shares are hybrid securities that provide
some of the attributes of bonds and common equities. Like bonds, preferred
shares commit to a regular fixed payment but their market value will fluctuate
with the performance of the company and the stock market in general. The
higher fixed dividend offered by preferred shares helps to offset market
downturns.
To learn more about this or similar investment products, consult
a professional investment advisor. Mutual funds are sold by prospectus
only. The information within this website is subject to our Mutual
Fund Investments and Statutory Sales Disclosure Information.
With files from Dynamic Mutual Funds
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, Fiscal Agents Money Management Newsletter
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