Monday, May 27, 2013

The Interest Rate Risk

Risk of risk-free investing

The interest rate risk is the risk of low earnings or reduced market value of a portfolio due to low future interest rates.

Lower interest rates affect retirement income in many ways:

  • Lower income on guaranteed income certificates and bonds.
  • At maturity, capital reinvested earns a lower rate.
  • Need to save more to have sufficient funds to provide adequate retirement income.
  • Annuities provide lower income when long-term interest rates are low at the time of purchase.

Strictly speaking, the interest rate risk applies to risk-free investments, such as Treasury bills, which are issued and guaranteed by Governments. This blog post expands this definition and discusses the risk of earning low returns on all types of fixed income investing, including bonds.

Stuck with low interest rates?

Low interest rates have been part of the economic landscape for many years, in part because of declining inflation over the last 20 years, and have been kept low to overcome the housing debacle in the United States. Having the economy churning with artificially low interest rates negatively impacts pensions, annuities and retirement savings.

The Bank of Canada cannot increase interest rates independently from the US without consequences. Higher rates in Canada will lead to inflow of investment, which in turns will strengthen the currency and adversely impact central Canada manufacturing and exports. The only option for Canada may be to move rates in tandem with the US.

Are higher interest rates desirable? It may seem to make retirement more affordable and secure, however, higher rates usually means higher inflation, which makes purchases of goods and services more expensive. It also increases the burden for those who carry mortgage and other debts.

Bonds and interest rates

If interest rates rise in the future, it will cause the value of bonds to fall. Interest rates and bond prices move in opposite directions. When interest rates fall, the value of bonds rise. Interest rates have been falling for a long time, which is why bond performance has been strong. When rates start to rise, bonds performance will inevitably suffer.

Long-term Government bonds have no credit risk, but they have a significant interest rate risk. A rise of 1% may cause long-term bonds to lose as much as10% of their value.

Interest rate risk can be quantified by looking at the "duration" of bond. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. It is expressed in terms of years. The sensitivity depends on the bond's time to maturity and its coupon rate.

By ensuring the duration of your entire portfolio is kept at a reasonable level, you are reducing your exposure to the interest rate risk.

Interest over time

It is "interesting" to look at money market returns over the last 50 years in Canada in light of inflation.
Interest rates often move up or down at about the same rate as inflation.

The 1980s and 1990s saw a prolonged streak of high real rates of returns (the difference between the nominal rate of return and the rate of inflation). But it has been succeeded in the last decade by zero or negative real rates of returns, and we may expect that the "new normal" will be an epoch of returns that barely exceed the rate of inflation, i.e., zero real returns for the foreseeable future.




[Source: DEX 91 Day T-Bill Index and Consumer Price Index, Canada All items]

Strategies

Are there strategies to help investors earn more on their cash and fixed income investments? With bond yields are at their lowest point in modern history, they don't earn sufficient returns to fund retirement needs.

Corporate bonds provide higher returns, but are more volatile and have a risk of default. Nevertheless, high quality issues and diversification make corporate bonds a viable option.

In order to generate adequate returns, equities must continue to be part of the mix during retirement. Minimizing volatility is achieved by investing in a diversified portfolio with emphasis on large capitalization and value.

As the economy improves, inflation will begin to increase. To keep inflation in check, central banks will increase interest rates to slow growth. When rates do rise, the value of bonds will fall.

Lowering risk in retirement

Bonds serve not only as a source of income but also as a way to lower the volatility of the portion of the portfolio that has equities. Many recommend reducing exposure to equities at retirement.

This is because time horizon shortens and the ability to make up losses is reduced. Risk appetite is lower, after all, if retirement is to be worry-free. As well, one or more years of poor returns may lead to a serious depletion of the portfolio when taking withdrawals (the sequence of returns risk).

So we may think eliminating equities altogether may be the best approach, but it may actually make your portfolio more volatile. More volatility means more risk, investment risk to be precise.

Keeping exposure to equities will help boost investment returns, while reducing volatility. Stocks are more volatile, but they have low correlation to bonds. The combined asset classes can produce higher returns while reducing volatility, because stocks do not move in tandem with bonds. The overall effect reduces the volatility of the portfolio.

Taxation

Interest is taxed as income. It may be sensible to hold interest-bearing investments first in a tax-free savings account (TFSA) to avoid any taxation of investment income, then in a registered retirement savings plan (RRSP) to defer income tax to a time when you are in a lower tax bracket.

Non-registered accounts are more appropriate for equities, as capital gains enjoy favoured tax rates and capital losses can be used to offset capital gains.

Fees and funds

If you hold part or all of your interest-bearing investments in a money market fund, pay special attention to fees. With current low or negative real returns on such investments, fees can wipe out return or make you lose capital in real terms.

Chasing higher returns

A ladder is a series of bonds that mature in succession, providing both yield and a steady stream of principal repayments as the bonds mature. It offers some protection against rising interest rates, because lower-yielding bonds can be reinvested into higher-yielding ones as they mature.

Bond ladders require significant investments to achieve proper diversification, but there are exchange-traded funds that simulate a bond ladder and can be purchased in any quantity.

Keeping up with inflation while taking little risk can be also be achieved by holding real return bonds. Real return bonds are Government issues that pay interest based on a formula linked to the current rate of inflation. There are real return ETFs and also funds, although the latter category may come with higher fees that can erode signficantly your returns.

High-yield corporate bonds could provide decent returns even if rates rise moderately, because rising interest rates would occur if economic conditions are stronger, lowering the chances of default for such bonds.

Annuities

Income annuities provide retirees with a guaranteed fixed income, despite changes in the interest rate environment. Prevailing interest rates will determine the amount of annuity payout that can be purchased from a given lump sum. Low interest rates have caused annuity premiums to increase. You can gauge the value of your annuity purchase by dividing the premium by the annual income. If it costs $200,000 to provide $10,000 per year for example, it will take 20 years to get back you premium. The higher this number, the better. A higher number shows the value you get from pooling mortality risks and investment income on your funds beyond your life expectancy.

It's difficult to predict the future direction of interest rates. This is why it may be a good idea to buy annuities in stages to take advantage of better premium rates if rates do increase. Nevertheless, making annuities as part of your retirement income mix will provide a basic layer of lifetime income together with the Canada Pension Plan and Old Age Security that you can count on regardless of economic conditions.

Planning for low interest rates

Currently, interest rates on both short and long-term instruments are low. In this environment, expect lower investment returns if a significant portion of your assets are in cash and fixed income.

This means more savings are required to fund your retirement, or you must plan for less if you can't add to your nest egg.

Software for individuals, advisors and financial services companies

Software for individuals, advisors and financial services companies
Retirement Planning

Featured Post

Quantifying Risk

Lightning and lotteries According to the National Oceanic and Atmospheric Administration, the odds of becoming a lightning victim in th...

About Us

My photo
RetireWare is a Web-based risk management and retirement planning software for individuals and financial advisors that's easy-to-use, full of rich visuals and comprehensive analysis. Try today and take advantage of our unconditional money-back guarantee. Know how much retirement income you can have. Build a plan and know where you stand.

Apeiron Software Limited

Apeiron Software Limited builds financial and retirement planning software for individuals, advisors and financial services companies. Our portfolio of products ready for customization and cost-effective outsourced model means no custom development projects tying up large internal and external resources. We also offer hosted solution for no infrastructure cost.

Follow by Email

© 2016 by Apeiron Software Limited. All rights reserved. Powered by Blogger.

 

© 2016 Risk Blog by Apeiron Software Limited. All rights reserved. Designed by Templateism

Back To Top