Judging by the media coverage of the Bank of Canada’s latest interest rate hike, one might think the end of the world is about to end.
That may seem like it for overleveraged borrowers, but it’s a new dawn for retirement savers with agonizing levels of exposure to volatile stock markets.
You have to go back more than three decades to find a time when higher-quality bonds did more of the heavy lifting in retirement portfolios; generate decent and reliable returns while reducing overall risk.
At that time, it was normal for investors in retirement or close to retirement to hold a large portion of their portfolio in fixed income securities.
That era could come back.
BRIEF HISTORY OF INTEREST RATES
This week’s 50 basis point hike takes the Bank of Canada’s benchmark interest rate to 3.75% from 0.25% at the start of the year.
In a continued effort to reduce inflation, the central bank is expected to raise its rate further to 4.25%, but this could change depending on how well it works.
While this may seem high by today’s standards, it corresponds to the period between 1995 and the 2008 financial crisis, when central banks around the world had to cut rates to keep the system running smoothly.
From the 1980s to 1995, runaway inflation pushed the benchmark rate to just over 20%, but from the 1950s to 1980s it remained in the 6% range.
FIXED INCOME ENTERS THE SWEET SPOT
Returns on fixed income securities fluctuate up and down with the benchmark rate. When last audited, two-year Canada bonds were yielding 3.9%, compared to well under 1% before the Bank of Canada began raising its rate.
At last check, one-year guaranteed investment certificates (GICs) were yielding up to 4.85%. If they move in line with expectations of another 50 basis point increase, the 1-year GIC yield will reach 5.35%.
Yields on longer-term government bonds, GICs and higher-quality corporate bonds could rise faster as the economy stabilizes.
BUILDING A FIXED INCOME PORTFOLIO
This is cold comfort to retired investors who have had to achieve their growth goals by venturing up the risk ladder to find dividend income in tattered stock markets.
With stock markets down, now is not the time to sell to generate cash for fixed income securities.
Building a balanced portfolio between equities and fixed income takes time, and this is where a qualified advisor can help reduce equity holdings as stock markets recover and choose the best entry points. for fixed income securities as rates rise.
Many would suggest “staggering” short-term maturities over time to create as many opportunities as possible to take advantage of the best returns as they rise.
INFLATION IS THE WILD CARD
The success of a fixed income portfolio also depends on how effectively the Bank of Canada manages to bring inflation closer to its 2% target.
These mouth-watering returns could be eaten up by the cost of living.
Rates on GICs reached 9% in the early 1980s, for example, when inflation was over 11%.
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This week’s lower than expected rise suggests that it is working. The latest reading on inflation shows that the cost of living fell to 6.9% from over 7% in previous months.
The Bank of Canada also lowered its inflation outlook to 4.1% in 2023 and 2.2% in 2024.
Even in the best-case scenario, the real return on fixed-income securities isn’t high, but finally having a guaranteed income in retirement could give savers a better night’s sleep.
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