Movin’ On Up: What Rising Rates Could Mean for Your Fixed Income Returns

Q3 | August 2018

Investment

Topic: Investments

Alana R. Buckley CPA, CA, CFA

August 14, 2018

Image used with permission: iStock/erhui1979


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Movin’ On Up: What Rising Rates Could Mean for Your Fixed Income Returns

Q3 | August 2018

Since 2016, interest rates have been rising gradually. The increase in the pace and consistency of the move has resulted in frequent conversations with clients about the role of fixed income in portfolios.

During these conversations, two questions come up regularly:

  1. Will I lose money on my investments if interest rates move higher?; and
  2. How is the Nexus Income Fund positioned?

To address Question 1, I first draw your attention to the article that John Stevenson penned which appeared in the July 2018 edition of Nexus Notes called the “Fixed Income Conundrum”. His article addresses why, despite relatively uninspiring income and return prospects, fixed income continues to play a key role in many investors’ portfolios. Building on John’s article, we explore further the idea that recent negative fixed income returns do not mean a negative total return for investors over longer periods of time.

Because fixed income-related conversations tend to be frustratingly technical and math-heavy, we’ve summarized the key points below. Those who are keen to get into the weeds with an example can click here. For now, here’s what you need to know:

Recently, investors have experienced periods of negative total return on bonds because of rising interest rates. Bonds experience negative returns when the capital loss from falling prices exceeds the interest income earned over a given period. This trend of negative total returns could continue as interest rates rise, but it does not necessarily mean a permanent loss of capital.

Why doesn’t it mean a permanent loss of capital? As the saying goes, bond investments don’t lose money. But for the sake of completeness, we need to add the following caveat: when held until maturity, investors in a bond will earn a positive return (the yield of the bond) over that period.

Things can get more complicated in between the purchase of a bond and its maturity date. When interest rates increase (and bond prices fall), it is possible that investors experience a negative period return, as we have seen lately. To reconcile the competing concepts of bond investments don’t lose money and as interest rates rise, bond prices fall, we must consider the time horizon. If a bond has a positive yield (as all of ours do!), any short-term losses will be reversed as the bond approaches its maturity date. Losses can be incurred, however, when a bond is sold before its maturity date and the funds are not re-invested in the bond market.

It is possible that we are still in the early stages of a long journey to higher rates. During this period, the pace and degree of shifts in interest rates will have a significant impact on the size of capital gains/losses incurred by investors. But, based on our expectation for a slow and uneven climb higher, we remain comfortable with our positioning in the Income Fund. We anticipate modest, but positive, returns over the medium term, and that the portfolio should continue to deliver stability, liquidity and a natural offset to equity volatility. While it likely won’t be a completely smooth ride, we expect that any short-term negative returns will be neither large nor long-lived.

Moving on to the second question “how is the Nexus Income Fund positioned?”, the positioning in the Fund aligns with our expectation that rates will be moving higher, as cited in our quarterly publications. We have constructed and continue to manage a conservatively positioned income-oriented portfolio. Unlike many traditional bond funds, we are not shy to position the Fund in a way that differs materially from the Fund’s benchmark (the Canada Universe Bond Index). For example:

  • The Income Fund currently has a duration of about 4.0 years vs. about 7.5 years for the bond universe, and it has no bonds with maturity dates more than 10-years away. Simply put, the Income Fund has a much lower sensitivity to a move in interest rates compared to typical bond funds that track the Universe.
  • The Income Fund can hold up to 20% equities at any given time. We believe that high-quality, income-focused stocks can act as a substitute for bond duration over the long term and in certain economic environments. The Income Fund currently holds its maximum allocation of 20% equities.
  • We don’t mind waiting. Recently the Income Fund has had as much as 8% of its assets in short-term money market securities. This limits the need to sell securities for liquidity and allows us the flexibility to use the funds when we feel the time is right.

It’s also important to keep in mind that we have already seen a move in interest rates. The yield on the bonds in the Income Fund has increased from 1.6% in mid-2016 to 2.8% as of September 30, 2018 without a significant shift to the maturity profile. On the positive side, as the yield on fixed income increases, the cushion against capital loss that would cause a negative total return increases and, as we re-invest cash from interest payments and maturities, we are re-investing at higher yields. This should result in better future returns. The other side to this is that investors have had to endure underwhelming returns on their fixed income portfolios for some time already.

Thankfully, the Nexus Income Fund continues to deliver performance that we can be proud of. Over 1, 3, 5, and 10-year periods the fund has earned returns (1) that are consistently better than the Canada Universe Bond Index. (For the 1- and 10-year periods ended July 31, 2018, the Nexus Income Fund returned 2.6% and 5.8% vs the Bond Universe returns of 2% and 4.3%, respectively). While the Fund’s benchmark is all bonds, and indeed a different maturity profile when compared to the Income Fund, Nexus’s relative positioning represents our view and strategy. As the numbers show, this has served us quite well over both the short and long term.

In practice, managing a fixed income portfolio involves balancing considerations such as credit quality, overall portfolio exposures and duration. In the current environment, we think Nexus’s approach of investing in high-quality credits and shorter-maturity bonds provides the appropriate blend of price volatility, conservative income, and liquidity. We remain positioned for higher interest rates and look forward to a more normalized central bank policy and higher yields.

I’d like to leave you with the message that not all income funds are built equally, and we continue to think this one serves a role in many investor portfolios. Please feel free to reach out to your Nexus contact if you’d like to discuss any of this in more detail. AB

(1) Returns presented are prior to the deduction of investment management fees.

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