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IMPACT OF RISING RATES ON BOND MUTUAL FUNDS
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Fund Library Q&A
Your questions about financial planning, investments, and portfolio management answered by an industry expert



By Robyn K. Thompson  | Friday, November 08, 2013


Q – I’m planning to invest in the PH&N High Yield Bond Fund and the CI Signature High Income Fund. How will future increases in interest rates impact these funds? – I. D., Toronto, Ontario

A – It’s impossible to forecast precisely how “future” increases in rates – or any other macro-economic factors – are likely to affect the performance of any type of asset class, whether it’s fixed-income or equity. However, there are certain guides you may be able to use when analyzing your investment choices in fixed-income funds.

The first, and most important, characteristic of fixed-income investments to remember is that as the prevailing level of interest rates rises, the price of bonds (and other fixed-income or fixed-income-type assets) declines. This has to do with the relationship between a bond’s price and it’s stated “coupon rate.” Bonds are priced on the open market so that their “yield” (basically, a bond’s stated coupon rate divided by its current price) remains competitive with yields of instruments of comparable quality and term. So (to take a very simplified example), if high-yield corporate bonds are currently yielding 4%, a bond with a stated coupon rate of, say, 3.5%, would be priced around $89 per $100 of face value, a discount of $11 from par, so that it yields about 4%.

The problem for bondholders here is obvious. When rates rise, bond prices decline, and so does the value of bond holdings in a portfolio. And this is precisely the problem bond funds are wrestling with now. Prevailing interest rates have been so low for so long that the next move by central banks is bound to involve some type of withdrawal of monetary stimulus. While this may not initially be an outright hike in interest rates, it may mark an end to a monthly program of Treasury bond purchases (quantitative easing) by the U.S. Federal Reserve Board, which markets are likely to see as the first steps to an eventual hike in rates.

The unpredictability of central banks

This happened just a few months ago when the Fed announced merely that it might begin “tapering” its quantitative easing program by the fall. Interest rates rose rapidly in anticipation of this, and fixed-income assets everywhere took a major hit as result. As it turned out, however, with the pace of global economic growth slowing through the summer, the Fed back-pedalled on this announcement, and has more recently avoided announcing or even hinting at any timing of reduction in monetary accommodation. And just the past week, the European Central Bank actually cut its key bank lending rate to 0.25% from 0.5%. Bond prices have recovered a bit, but it’s anyone’s guess how long that will last.

Bond fund managers have a number of techniques they use to deal with the uncertainties of interest rate movements. They may, for example, adjust the average term to maturity of their portfolio (shorter-term bonds tend to be less volatile than longer-term issues). They may adjust something called “duration” (a measure of how many years it would take to repay the price of a bond from internal cash flow) – the higher the duration, the greater the risk. In high yield funds, which tend to hold corporate bonds, they could also tinker with quality, defensively increasing the number of BBB-rated bonds, for example, while reducing the number of lower-rated issues and increasing cash.

Funds getting defensive

For example, the PH&N High Yield Bond Fund you mention is a High Yield Fixed Income fund. In their September fund commentary, the managers stated that “the Fund remains relatively defensively positioned with a continuing focus on shorter- and intermediate-term bonds (i.e., those with three- to seven-year effective maturities) issued by higher-quality borrowers in more stable industries.” Note, though, that this fund is closed to new investors; existing unitholders may, however, purchase additional units.

The CI Signature High Income Fund, which you’re also considering, is a Global Neutral Balanced fund, which holds a portfolio of both fixed-income and equity assets. Naturally, its fixed-income holding face the same challenges as the PH&N offering. In their September report, the fund’s managers also took a more defensive bias to fixed-income assets, writing that “the prospect of higher rates will continue to create headwinds for yield-oriented securities. Having said that, we expect rates to remain structurally low for a long time as governments and consumers continue to reduce debt, which means that higher-yielding investments will remain in demand.” For more information and analysis on this fund, read Dave Paterson's recent report here.

Risk metrics and FundGrade ratings

It’s also helpful to look at some of the performance and risk metrics for mutual funds before you make a decision. At a minimum, investigate the fund’s standard deviation, a common measure of a fund’s variability of return. For the funds you’re looking at, as of Sept. 30, 3-year standard deviation was 2.62 for the PH&N fund compared with 5.1 for the category average. The CI fund posted a standard deviation of 4.6 compared with a 5.7 average for the category.

In addition, a good clue to the quality of the fund, and thus a place to begin your research is with the Fundata FundGrade® ranking. The PH&N fund received a B-grade for September, while the CI fund rated an A-grade in addition to being awarded the  Fundata FundGrade A+ Rating™ for 2012.

Note that what I’ve described here should comprise only the beginnings of your research into these funds as potential investment candidates. To properly place such investments in the context of your overall portfolio, it’s always best to consult with your investment advisor or financial planner. – Robyn

Robyn Thompson, CFP, CIM, FCSI, is the founder of Castlemark Wealth Management, a boutique financial advisory firm specializing in wealth management for high net worth individuals and families. Contact her directly by phone at 416-828-7159, or by email at rthompson@castlemarkwealth.com for a confidential planning consultation.

 Submit a question on investments, financial planning, or portfolio management. We cannot reply personally and cannot guarantee your question will be used.

Notes and Disclaimer

© 2013 by the Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

The foregoing is for general information purposes only and is the opinion of the writer. Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.

 
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