Wednesday, December 7, 2022

With the Bank of Canada announcing another interest rate hike, it’s a great time to revisit your investments that are more sensitive to fluctuating interest rates.

Canada’s central bank has raised its key benchmark rate another 50 basis points (0.5%), to 4.25%. This is bad news for those holding variable rate debt (such as adjustable-rate mortgages and lines of credit), and those holding investments that are highly sensitive to changes in borrowing rates (such as longer-term bonds).

When investing in bonds, there is an inverse relationship between bond prices and interest rates. This means that when interest rates rise, bond prices fall, and vice versa. This occurs because the present value of future interest and principal payments falls as the opportunity cost of tying up your money rises (you could invest your money into other assets now paying a higher rate of interest if given the opportunity – this makes your existing fixed rate investment assets less attractive). Preferred shares, which often have fixed dividend payments, also experience this problem.

When investing in stocks, the present value of any future cash flows also falls as rates rises. These future cash flows could be dividends, or the anticipated value of earnings that new projects might bring. For this reason, as well as more than a fair share of economic uncertainty on the horizon, we have seen many stock prices fall in tandem with bonds year-to-date. Often, those stocks most sensitive to declines of this nature are those with fixed payments coming from their customers, such as utilities, or those with cash flows only coming far into the future, such as some in the technology space.

On the bright side, the Bank of Canada might be nearing an end to the rate tightening cycle. Perhaps even just another 25-basis point, or 50-basis point move coming down the road in January. The housing market is showing signs of weakness, and inflation pressures are easing. These are both good sings for those waiting for lower rates.

Thank you.

Matthew Clarke


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