June 07, 2011

Are investors setting themselves up for disappointment?

The low level of interest rates helped drive a significant amount of investor interest in income funds and fixed income investments.  However, as improved signs from the economy point to an environment of increasing short term interest rates, how are these investments expected to perform?  Are investors setting themselves up for disappointment?

Over the course of 2010, Canadian investors purchased more than $6 billion of balanced funds with an income bias.  For some investors, these funds offer a more stable income stream to fund their spending needs.  For other investors, these strategies can provide less volatility than a traditional balanced fund. Typically these funds will hold a balance of fixed income or bond investments guaranteed by governments or corporations as well as equities or stocks that generally pay a dividend.  These types of investments are considered to be interest rate sensitive as they tend to fall in value as interest rates increase and increase in value as interest rates fall.

It is broadly anticipated that the Bank of Canada will once again commence raising interest rates this year.  As the value of interest sensitive investments tends to fall as interest rates increase, many investors are expecting that the coming economic environment might depress the returns from income funds.  However, this generalization does not apply to all income funds as some have been structured to reduce the impact of rising rates. There are three main factors that can help protect an individual fund: first, the term of the fixed income investments, second whether the fixed income investments are government guaranteed or backed by corporations and finally whether the fund has holdings in dividend paying stocks.

First, just because short term interest rates are increasing does not necessarily mean that interest rates for all government securities are increasing.  Depending on the speed and magnitude of short term interest rate increases, longer term interest rates can be stable or even declining.  As such, income funds that have exposure to fixed income investments with a well diversified set of maturity dates may be somewhat insulated from increasing rates.

Second, just because government rates are increasing does not mean that all fixed income yields will increase.  Corporate bonds  tend to trade at  a yield premium to government bonds of the same maturity.  This yield premium tends to decline as the economy improves.  In some periods, this decline in credit spreads is sufficient to offset the increases in government backed interest rates. As such, income funds that have significant corporate credit exposure can sometimes be insulated from increasing government rates.

Finally, some income funds have significant exposure to dividend paying equities such as banks or utilities. These types of investments are also driven by expectations for earnings and dividend increases.  As the economy improves, equity investors tend to revise up the earnings expectations for various corporations.  Such revisions can stimulate price increases that even offset the effect of  increasing interest rates.

When looking at purchasing an income fund, it is critical to look at the underlying investments that are held within that fund.  Despite expectations of increasing short term rates, funds that have exposure to corporate credit with a broad set of maturity dates and dividend paying equities may be able to provide reasonable returns over the long-term.

The article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

Jim Gilliland

Managing Principal, President & CEO