A little over a year ago, the Bank of Canada (the Bank) surprised markets with a rate hike in July 2017, kicking off its rate normalization path. Yields, particularly on the front-end of the curve, have moved higher: the 2-year Government of Canada yield has risen by nearly 100bps to 2.06% (as of 8/31/2018), leaving investors wondering what to do with their bond portfolios.
Against this changed market landscape, we believe there are three things fixed income investors should focus on to help navigate a rising rate environment.
1. Diversify away from domestic exposure
Moreover, Canadian bonds represent just 3% of the global fixed income market*. Investors who stay local are in effect leaving 97% of the alpha opportunity, such as global credit (including Investment Grade, High Yield, Loans and Emerging markets) and non-domestic inflation protection, on the table. In this challenging bond environment, it’s more important than ever for investors to seek diversification and source global opportunities.
Many Canadian investors tend to prefer domestic bonds which offers limited breadth and diversification. Exposures in Canadian fixed income are concentrated in Investment Grade bonds, primarily from Federal and Provincial Governments and corporations within Financial, Energy and Infrastructure industries.
2. Be active to adapt to the changing market landscape
For many bond investors, the knee-jerk reaction to rising rates is to simply reduce duration. Instead, we believe it’s worth looking at the balance between interest rate and credit risks across their entire fixed income allocation. By actively adjusting exposures and taking advantage of the global opportunity set, a nimble investor can add high yield or emerging markets exposures for potential income to help offset rising domestic interest rates.
3. Remember what your fixed income investment is for
Too often investors are tempted to act if their investments are falling in price, as might be the case for bonds when rates start to rise. However, investors should not forget the purpose of their bond allocation: whether it’s to meet income needs or as a diversifier against equity risk (or both), a diversified bond investment plays a crucial role in a well-balanced portfolio.