Don’t Try to Predict Interest Rate Movements

There is one recommendation that I received early in my wealth management career that has served me well: do not try to predict interest rates.  There are way too many moving parts involved.  To predict interest rates you must try to decide whether we will see inflation or deflation (rising or falling prices).  You must also try to gauge the how the market is pricing in future inflation or deflation.  Supply and demand for credit investments also plays a role.

Central bankers around the world are keeping short-term rates low and making purchases in other parts of the bond market.  There are a lot of factors to consider.  Even if you can predict the direction of rates you could still get the timing wrong and lose money in the meantime.

Rates Are at All Time Lows

But with rates at or near all-time lows (in the history of interest rates!) investors have become increasingly concerned with what happens to their bond portfolio when rates do eventually rise.  And these investors have a right to be worried.  At some point the money being pumped into the global markets by central bankers will take hold and inflation or a rotation out of low yielding securities will cause interest rates to rise.

Once rates rise, income producing assets will suffer price losses.  This is because bond prices and interest rates are inversely related.  So as rates rise and investors are able to get higher rates in the market, the bonds you hold will fall in price to make up for the yield difference.

This make a lot of income seeking investors nervous, especially those that need current income to fund their spending needs.  The perfect way to play the rising rate environment will only be known in hindsight.  If you had tried to predict the turning point in interest rates or the bond market in the last few years you would have been sorely disappointed by the fact that rates have continued to fall.

Even though you shouldn’t try to predict the rise of interest rates that doesn’t mean you can’t make some changes to your portfolio to be ready for the time when rates do rise and inflation kicks in.

Historical Interest Rates

They say history doesn’t repeat itself but it often rhymes so let’s look back at the last time we had a rising rate environment to see how things played out.  We have to go all the way back to the 1950s, 60s and 70s since rates have been on a decline for a very long time.  This is a graph of the 10 Year U.S. Treasury rate from 1950 to the present:

Fig. 1: 10 Year U.S. Treasury Rates

As you can see there was a steady rise in interest rates during the 1950s and 1960s. Then in the 1970s, inflation really took hold.  The Fed Funds Rate was ratcheted up by Fed Chairman Paul Volcker to try to subdue the threat of hyperinflation and he was successful but only after interest rates hit double digits.

You would think returns on bonds were destroyed in this rising rate environment.  Actually they weren’t that bad.  Here are the annual returns by decade for 10 Year Treasuries during this period of rising rates:

Fig. 2: 10 Year Treasury Total Returns

Does that mean that rising rates don’t hurt bonds because returns were not that bad?  On an absolute basis, these returns were positive.  And the largest annual loss in that time was only about 5%.  But if you look at the inflation rate over this time period and see how it affects your real returns, you can see how bonds are really hurt by rising rates.

I’ve added the annual inflation numbers (measured by CPI) over those same decades and the corresponding real (after-inflation returns) of bonds:

Fig. 3: 10 Year + Inflation Adjusted Returns

You can see how a combination of rising inflation and rising interest rates led to a loss of purchasing power if you were holding bonds during this time frame.  After inflation in this 30 year stretch you actually would have lost about 30% of your purchasing power by investing in bonds (stocks were hurt by inflation in the 1970s as well, but they did much better in the 1950s and 60s).

Rising rates don’t necessarily hurt bond returns that badly.  You could still use bonds as a way to reduce volatility in your portfolio, just with lower returns than we’ve seen recently.

Inflation is the real problem.  The reason bonds perform poorly with rising inflation is because your fixed interest payments are worth less and less over time as purchasing power is eroded.  But it’s not like a stock crash where large losses happen very quickly and you have no time to react.  It happens slowly over time and eats up your returns in small chunks.

After the difficult 1950-1980 period for bonds we have seen rates on a downward spiral with only periodic and minor setbacks along the way.  Returns in the 1980s for bonds were almost 12% per year and in the 1990s and 2000s they gave you a yearly return of over 7% and over 6%, respectively.

 How to Proceed With Rates So Low

Now that you have this information, how can you use that to protect your investment portfolio?  Just because I think you should not try to predict interest rates does not mean I think you should ignore them all together.  Investing requires us to weigh probabilities to make decisions based on what we have seen in the past but with an unknown future ahead of us.

 1. If Rates Rise

If rates rise, the longer maturity bonds (20-30 year maturities) will get hurt the most.  So you should stay away from longer dated bonds.  That’s an easy one.  Rates could continue to go down and they might, but they can only go so low.

2. Rising Inflation

Historically, in a period of rising inflation, inflation-linked bonds, emerging market bonds and commodities tend to do well.  If we are in a period of rising economic growth but inflation stays under control, stocks, corporate bonds, emerging market bonds and commodities have done well in the past (this would be the last four years or so).

3. Falling Inflation

With falling inflation, stocks and government bonds usually perform the best (again this has been present the past few years).  And in a falling economic growth environment, inflation-linked bonds and government bonds have done the best.

The best way to plan for a potential rising rate environment is to have a diversified portfolio of bonds across different geographies and asset type.  You can also use a laddered approach by blending short-term and intermediate-term bonds to decrease your interest rate risk.

 Conclusion

Since it’s impossible to predict how things will play out with the global economy it makes sense to have all of your bases covered. It would be great if you could put the perfect portfolio together at just the right time when rates rise but that will be nearly impossible.  You can minimize your risk by spreading your bets and having a diversified asset allocation plan in place.  You can also lower the maturity of your bond portfolio and have inflation hedges in place if rates ever do shoot upward.

Just don’t try to reach for yield and use stocks in place of your bonds in search of extra income.  Reaching for yield can lead to increased risk in your portfolio.  I will cover this in more detail in part 2 of this series on rising rates.  I will go over how you should look at higher yielding assets such as preferred stocks, high yield bonds and REITs.

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Ben Carlson

I agree with you that those who can stick it out and buy during panics will do very well for themselves. Buffett said that cash combined with courage in a crisis is priceless. I'm a long-term investor as well and buying in '08 was hard to do but I knew it would make sense over my longer time horizon.

But it seems like 90% of investors don't understand this. Almost $1 trillion has poured into bond mutual funds in the U.S. since '09 while stock mutual fund flows have been negative (go figure). So bonds investors need to be aware of the risks of investing at such low rates and how it will affect their portfolios. Most bond investors have never had to deal with this. Since the mid-1970s the BC Aggregate bond index has only had two negative calendar years and the largest loss was 3% or so.

So you're right that the volatility going forward will be higher than it's been in the past but bonds will still not face the large drawdowns that stocks can have in very short time frames. This will matter the most to retirees that will need to take distributions from their portfolios. In a dividend portfolio the only time this would matter would be if your spending needs were greater than the dividend yield.

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The Weekly Lineup

Sell in May and Go Away? A phenomenal article by Louis Basenese, chief investment strategist at Wall Street Daily, tells you exactly why you should not implement the strategy. In, Sell in May? Not According to These Three Charts, Louis clearly shows why you should ignore the short-term swings and remain a long term buy-and-hold investor. A must read post!

Buy and Hold vs Sell in May. courtesy of www.wallstreetdaily.com

Speaking of buy-and-hold, there’s buy-and-hold, and then there is really buy-and-hold! So what does long term investing really mean to you – 10 years or more? Time is irrelevant to Dividend Growth Investor, and he explains why he would not sell a dividend stock ever after a 1000% gain.

Dividend Mantra is bullish on dividend stocks no matter what the market is doing. Mantra discusses current difficulties in allocating capital, but also discusses the difficulty with paying a premium for top-notch companies.

Dan Mac at Dividend Growth Investing thinks many dividend stocks are actually overvalued, based on the Price-to-Earnings ratio. Dan discusses 20 stocks you should not be buying right now.

Over at A Wealth of Common Sense, Ben thoroughly discusses the lost decade and How to Invest 100% of Your Portfolio in the Stock Market.  But what if you had only invested in big blue-chip dividend paying stocks?  Was there a lost decade? Read Ben’s post and find out.

Over at My Own Advisor, Mark asks the question Is Coca-Cola the perfect dividend paying stock? Well, not much to say here – I think it is. Again, who cares what the stock market does, buy KO and enjoy the dividends.

The Passive Income Earner discussed International Allocation through Conglomerates.

The Dividend Guy (aka Mike) is bored of utilities and banks! So he’s written a couple of stellar posts on the toy companies this week. Check out his super-detailed dividend stock analyses on Hasbro and Mattel. Awesome!

Have a nice weekend everyone!

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Dividend Growth Investor

Thank you for the mention DN. At this stage of the market, investors might need to start buying stocks that are different than the ones they previously owned. I bought some AMP, and the big 5 Canadian banks this year. Unfortunately, the Coca-Cola's of the world do not make sense to be bought. But they make a lot of sense to be held on - I am holding on for a 1000% gain there ;-) ( albeit in 2 - 3 decades)

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Bell Aliant: 7.11%

The telecom giant has gone through a much needed transformation over the last few years.  From multiple mergers to restructuring the company into deferent components, the company has transformed its self into a communication company giant. Based in Atlantic Canada, with over 9,000 employees, this company is still 44% owned by its larger parent company of Bell  Canada.

The fundamentals are what investors expect from a big telecom company. Steady earnings, a modest P/E and a good healthy dividend.

And for investors looking for low volatility, this is a good pick.  The beta is 0.027.  With earnings per share (EPS) at 1.44 and a P/E of 18.50, this is definitely not a growth story.  Valuations still rank in the top half of all telecom/utilities companies in Canada.

The big plus is the dividend.  There are few telecoms that can match the 7.11% dividend.

Technically, BA is slowly advancing over the last two years.  Currently at a resistance level of $26.50-$27.00, the stock is expected to continue its gentle rise in 2013 toward the year-end target of $29.

Bottom line: For investors looking for a low volatile stock with a high payout and a slow rise in price, BA is hard to beat.

Artis Real Estate Investment Trust

AX/UN is a diversified Canadian real estate trust that invests in office, industrial and retail properties since 2004.

Artis executives have planned an aggressive but disciplined grow strategy for the company.  They have built up an impressive portfolio of commercial properties in Canada and the U.S.  Most of their assets are located in Western Canada.

The fundamentals are on par with its competitors.  EPS is 3.21, trailing P/E is 5.20 and the beta is 0.879.

The dividend is the highest within the Canadian real estate sector.  With a 6.49% dividend payout, the yield from AX/UN is almost a full percentage point above its closest competitor.

The stock price is a little misleading.  At first glance, an investor would think that AX/UN is a growth stock verses a real estate trust.  The stock price has moved up 41% in the last 12 months.  Undoubtedly because of the aggressive growth of the company and the large dividend.

AX/UN is starting to breakout.

Bottom line: Artis Real Estate Investment Trust is expected to continuing to advance in this current business cycle.  With an experienced management team, an aggressive growth strategy plus an impressive dividend. this stock should appeal to a wide variety of investors.

ConocoPhillips: 4.6%

This major player in the global energy sector is both on a strong financial footing and it also has a hefty dividend yield of 4.6%.

Earnings from current operations remain robust but have lagged many of its competitors.  COP recently has sold some of its lower producing assets and have added some new assets, which are primarily in the Gulf of Mexico, will deliver long-term growth to the company.  Cash margins are also expanding in Q4 and Q1.

COP is trading at a reasonable multiple of 8.75 and forward P/E is expected to be 9.86.  Earnings per share (EPS) is a solid 6.72 and ROE is a robust 13.10%.

COP has broken out.  Price support is at $57.

The dividend yield is 4.60% which should keep most dividend investors content.

The outlook on COP is modest.  Our models point to a $64 target.  There is some price resistance building at $61.00-$61.50 and support at $56.

 Bottom line: COP has solid fundamentals and little reason to be worried about the dividend payout.  Though the stock price is not expected to advance too much further, there is still another 8%-9% upside anticipated. Coupling this plus the 4.6% dividend and COP could be an attractive addition to a portfolio.

Occidental Petroleum: 2.95%

Low payout ratios are not a guarantee of future dividend growth, but when a company only dishes out a small portion of its earnings, and those earnings are substantial, there is a very good chance that the dividends will increase.

Occidental Petroleum (OXY) has a payout ratio of only 35.83%.  This is fairly small compared to the thousands of U.S. companies that issue dividends.  The fundamentals are impressive on this company  too.  The p/E multiple is 12.22, EPS at 7.09 and a healthy ROE at 11.42%.

Q1 earnings also beat the street estimates by a good margin as new and existing production adds to the bottom line.

The outlook for the rest of 2013 is for a potential stock buyback.  Earnings should continue to increase into 2014.

Technically, this stock is just starting to move.  After bouncing  off of the $75-$80 base for most of 2012, OXY looks to be starting to rise.  Buying momentum has recently pick up as has buying volume.

The improving earnings appear to be catching investors attention.

Bottom line: This higher beta company (1.5) looks as if it is finally breaking out of a year long base. With improving earnings, a good dividend yield, this stock is a favourable bet for a both capital gains and future dividend increases.

With a target of $98, there is the potential for a 17% return, counting the 2.9% dividend.

Donald W. Dony, FCSI, MFTA is a technical analyst.  He is also an instructor for the CSI, frequent national and international speaker on stock market trends and editor of the Technical Speculator.com, a website focusing global economic and technical trends.   Through the monthly newsletter,  he also reviews individual equity opportunities for income and growth.

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Weekend Links – “Sell in May and GO AWAY!”

[...] For all those dividend investors out there, Ninja had a post about “Dividend Investing – Telecom, Real Estate and Energy.” There are a couple companies I never thought about, so it was a pretty interesting read! [...]

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  Artis Real Estate Investment Trust, Bell Aliant Communications, ConocoPhillips, featured, Occidental Petroleum

This presentation is from the Take Control of Your Financial Future Seminar, held on Saturday April 20th, 2013, at the University of British Columbia.

The seminar was sponsored by the Canadian MoneySaver. On behalf of Canadian MoneySaver, I would like to thank those who attended the seminar! I’d also like to thank CMS for the opportunity, permission to share my slides, and to those who came up and talked with me during the breaks. It was a pleasure to meet CMS readers!

My presentation was titled:

Sell Your Mutual Funds:
Buy Index Funds and Dividend Stocks, and Start Making Money Now!

The presentation was divided into four parts:

• Part 1 – Mutual Fund Fees and Performance
• Part 2 – Build Your Own Mutual Fund
• Part 3 – Buy What the Funds Buy
• Part 4 – Making the Switch

You can download my presentation slides and notes at:

Now available to newsletter subscribers only.

Note: Will only be available to newsletter subscribers after May 4th, 2013.

Be sure to read my copyright and disclaimer notice before downloading. If you found the presentation useful you can follow me on twitter, facebook, or subscribe to the Dividend Ninja Newsletter.

Cheers!

Recent Comment

The Dividend Ninja

Hey Ben, yes it certainly is!

You'd have to earn at least 2% returns per year, on the largest Canadian equity funds, just to break even. With a lower MER you still run into the problem of lagging behind the index - the odds are just not in your favor.

Cheers

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  Canadian MoneySaver, Dividend Stocks, ETFs, featured, Mutual Funds, UBC Seminar

Investment fraud isn’t something we consider until it is on the front-page news and media. But investment fraud is more common place than unsuspecting investors may realize. A 2012 National Investment Fraud Vulnerability Report, commissioned by the British Columbia Securities Commission (BCSC), found that 1-in-5 Canadians aged 50 plus, are vulnerable to a potentially fraudulent investment offer. According to the report, 23% of British Columbians said they had been a victim of fraud, pointing to a need for additional emphasis placed on education about the investment fraud warning signs.

The British Columbia Securities Commission (BCSC) specifically exists to protect B.C. residents and provide them with the tools and information needed to protect them against investment fraud.  BCSC recently launched an iPhone and iPad app dedicated to this mandate.

The Be Fraud Aware mobile application for iPhone and iPad helps to access real-time news, pertinent information, and on-the-go protection against fraud. Specifically the app helps investors to search for and report potential fraudulent schemes. There are some videos as well, to show what the app does and how it works.

Here are some of the app features:

• Get updated with the latest news and alerts
• Learn to spot investment fraud
• Check the CSA’s national disciplined persons list
• Access the BCSC’s Investment Caution List
• Use the Scam Glossary

Most of us who are DIY (Do It Yourself) investors purchase our securities through a discount broker via a stock exchange, which is regulated and monitored by various securities exchange regulations. Many fraudulent schemes however, exist in the “alternative marketplace” and with “private placements”.  This makes investors who don’t invest through an exchange, discount broker, or licensed dealer, even more susceptible to fraud and investment schemes.

The Be Fraud Aware web page has some excellent resources to help and educate investors. These include fraud warning signs, how to spot an investment scam, and how to identify a con artist. Most importantly, there is also a link on how to report investment fraud. Be sure to check out the videos on the Fraud Watch page to see how a potential fraudster works, and how they build an investment scheme.

Whether you invest in the alternative market place or not, being aware of how investment fraud works, and how you can protect yourself, is everyone’s business.  The Be Fraud Aware campaign, by the B.C. Securities Commission, is an excellent resource to educate and help investors.

Bottom line, if an investment offer is too good to be true, then it is!

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Friday fun: articles that sparked my interest this week. | Transforming the Now

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  BC Securities Commission, BCSC, Be Fraud Aware, featured, Investment Fraud