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For the past several months, North American investors have been keenly focused on rising inflation and its impact on everything from interest rates and company earnings, to consumer spending and much more. While central banks initially viewed rising prices as a short-term effect due to pandemic-induced shortages, various inflation gauges indicate that high inflation could be an issue for quite some time. In February 2022, U.S. inflation reached 7.9%, its highest reading in four decades, while Canadian inflation in February climbed to 5.7%, its quickest pace since August 1991.
Central banks have typically raised interest rates in an effort to stave off inflation. Rising interest rates can create a number of attractive investment opportunities in a wide range of other assets and investment strategies – including fixed income strategies with floating rate characteristics, rate-reset preferred shares, and even equities in certain sectors that benefit from rising interest rates, like financials.
In the current environment, we believe that active management provides a real advantage over passive investment approaches. Unlike passive ETFs, which are designed to track an index, active ETFs are actively managed by a portfolio manager who can adjust a fund’s holdings and make tactical shifts in response to market conditions – especially anticipated changes in interest rates.
1. Fixed income
Floating-rate funds. Unlike traditional bonds, which pay a fixed rate of interest, floating-rate funds have a variable rate that resets periodically. When interest rates rise, the fund’s holdings adjust to the new rate. Therefore, exposure in a floating-rate fund can enhance returns when rates trend higher. Floating-rate funds are also an attractive option for investors who want to maintain a portfolio return that keeps up with the rate of inflation. The best time to buy floating rate funds is when rates are low (or have fallen rapidly) and are expected to rise.
Tactical bond funds. Traditional bond prices have an inverse relationship with bond yields. Consequently, in a rising rate environment, an active manager can help minimize interestrate risk by keeping a fund’s duration1 short. It is therefore ideal to have duration flexibility in your core fixed income portfolio.
An active tactical bond fund offers a wide range of investment flexibility. A portfolio manager has the ability to manage not only interest-rate risk but also credit risk, by reaching for higher yields during expanding markets, while opting for higher quality bonds (with a lower risk of default) when markets are volatile. This is in marked contrast to passive bond funds, which may be exposed to substantial interest-rate risk in an inflationary environment.
2. Preferred shares
An asset class that should continue to benefit from rising rates is preferred shares. Preferred shares are often described as a hybrid security that combines the stable and consistent income payments of bonds with the equity ownership advantages of common stock. In Canada, where the preferred share market is primarily composed of discounted rate-reset preferred shares, higher rates may mean higher interest returns and hence higher share prices. Another appeal is that income from preferred stock gets preferential tax treatment, since qualified dividends may be taxed at a lower rate than bond interest.
3. Equities: Financial services
Financial services companies (i.e., banks and insurance companies) tend to see their profit margins increase in a rising rate environment – and also their share price. As interest rates increase, banks can earn more from the spread between the interest rate they pay to deposit holders (in savings accounts and certificates of deposit) and what they can earn from debt like Treasuries. Rising rates often point to an expanding economy, which usually means fewer loan defaults weighing on their bottom line. That’s good news for shareholders, who may even receive increased dividend payments as a result.
While not many of us like rising prices, higher inflation can also be seen as an opportunity to enhance your portfolio by adding exposure to certain asset classes that can benefit from inflation. We believe the best way to do this is by utilizing actively managed solutions.
1. A bond’s duration is a measure of the sensitivity of the price of a bond to a change in interest rates. (As a general rule, for every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration). It’s therefore critical to limit a fund’s duration when rates are rising.
Alan Green is Director, ETF Capital Markets, at Dynamic Funds. Peter Tomiuk is Vice President, ETF Distribution, at Dynamic Funds. This article previously appeared in the Winter 2022 issue of Your Guide to ETF Investing, published by BrightsRoberts Inc. Used with permission.
Dynamic Funds offers an array of active ETFs, including Dynamic Active Investment Grade Floating Rate ETF (TSX: DXV), Dynamic Active Tactical Bond ETF (TSX: DXB), Dynamic Active Preferred Shares ETF (TSX: DXP), and Dynamic Active Global Financial Services ETF (TSX: DXF). For more information visit www.dynamic.ca/ETF.
Disclaimer
© 2022 by Dynamic Funds. All rights reserved. Commissions, trailing commissions, management fees and expenses may be associated with mutual fund investments, including ETFs. Please read the prospectus before investing. Mutual funds and ETFs are not guaranteed, their values change frequently and past performance may not be repeated. Views expressed regarding a particular investment, economy, industry or market sector should not be considered an indication of trading intent of any of the mutual funds managed by 1832 Asset Management LP. These views are not to be relied upon as investment advice nor should they be considered a recommendation to buy or sell. These views are subject to change at any time based upon markets and other conditions, and we disclaim any responsibility to update such views. To the extent this document contains information or data obtained from third party sources, it is believed to be accurate and reliable as of the date of publication, but 1832 Asset Management L.P. does not guarantee its accuracy or reliability. Nothing in this document is or should be relied upon as a promise or representation as to the future. Dynamic Funds® is a registered trademark of its owner, used under license and a division of 1832 Asset Management L.P.
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