Navigating Bonds In A Rising Rate Environment

To set the stage - bond prices and bond yields move inverse to one another. When interest rates rise, bond values will inevitably go down - all else equal. So with the Fed and Bank of Canada signaling several rate hikes in the months ahead, how can you invest profitably in bonds?

It is important to note the why behind central banks decisions to raise rates. With inflation running rampant - central bankers increase borrowing costs to remove cash from the system and dissuade individuals and businesses from purchasing more goods. With that in-mind, lets explore three fixed income areas that don't lose out with higher rates.

Real Return Bonds

Real return bonds or inflation-linked bonds adjust the coupon payment to the consumer price index (CPI). This means the bond holder receives a higher coupon payment when inflation is high, keeping your purchasing power constant.

Real return bonds are created by government entities, and therefore offer increased protection vis-à-vis a corporate bond. The major hurdle with investing in a real return bond is the upfront capital required. A Government of Canada bond's minimum investment is $5,000. However, there are several ETFs like the iShares Canadian Real Return Bond Index ETF (XRB) which can be purchased for a fraction of the amount, and with increased diversification.

The US Fed calls these bonds Treasury Inflation-Indexed Notes and perform the same job as a Real Return bond does in Canada. The Mackenzie US TIPS Index ETF (QTIP) provides exposure into the US fixed income market.

Floaters

These are floating rate bonds which move dependent on the going market rate, often LIBOR. As inflation increases, investors demand higher yields from their fixed income products. When owning a fixed rate bond, like the US 10-year, the purchasing power received is slowly eroded with inflation. However, a floater will make this adjustment and increase its payout as LIBOR increases.

While Real Return bonds are focused on government debt, you can get access to corporate floaters which often pay higher coupons, albeit with higher risk.

Popular ETFs in this category are: XFR from iShares and HFR from Horizons.

Bond Proxies

Okay we lied when we said three fixed income classes. Bond proxies are actually equities but behave like quasi-bonds due to their relative safety and ability to pay consistent dividends. REITs and utilities are the two staple sectors here, while you can also bucket in consumer staples and banks to this category.

REITs

Real Estate Investment Trusts are public companies which own and operate real estate properties including health care, residential, offices and industrial facilities like a warehouse. These different REIT categories are important to note because they depend on different external factors.

For instance, office REITs are dependent on companies requiring their employees to come into the office - and employment/economic growth to continue to rise. Industrial REITs are driven more so by economic productivity like GDP growth and health care REITs by government spending.

REITs in general stand to benefit from our current economic climate on the inflation front. They can charge higher rents to their customers, and generate increased profits as a result. Because these are highly levered companies, when governments inevitably raise interest rates, REITs will see some erosion to their bottom line as their debt servicing cost increase. However, rates would need to increase faster than inflation for that to happen.

Popular ETFs in this category include: XRE from iShares and ZRE from BMO.

Utilities

Like REITs, utilities benefit from inflation because they can charge higher rates to customers. It is important to note, many utilities companies are regulated and would need government support to hike your electricity bill. On top of this, many utilities names are trading at very high multiples. Typically we see multiples (like Price-to-Earnings) erode with inflation which could end up hurting these companies. For utilities to benefit, we would want to see stable inflation. Keep an eye on XUT for Canadian Utilities exposure.

Consumer Staples

We have all felt the pinch at the grocery store lately so why not buy the grocery store itself? Consumer Staples, which include grocers are the final main Bond-proxy category, and one that is tied to inflation. These are often stable companies, typically in the food business, which have a solid history of paying dividends in Canada. Look to ETFs like STPL and XST for staples exposure.

Concluding Thoughts

By adding variable rate fixed income to your portfolio, and unwinding from fixed rate bonds, you can hedge your portfolio from inflation. Look to real return bonds or floaters to aid with this.

If you want quasi-bonds look to some of the bond proxy sectors which include REITs and Consumer Staples and Utilities for areas with positive inflation correlation. While these bond proxies are more volatile than bonds themselves, they can be a safer bet than a pure equity play.

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