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- Bank of Canada’s expected interest rate hikes in 2022
- What rising rates mean for fixed income investments
- How investors can position themselves for success
As the year closes, many of us are planning family gatherings either in person or virtually. In some families, there’s that one uncle who puts a damper on the festivities and no one wants to sit next to. In 2021, the investment world’s unfun uncle was bonds.
As we went through 2021, major central banks were providing support to their respective economies primarily through bond purchase programs (often referred to as quantitative easing). The support was meant to ease the economy through the disruption caused by the exogenous COVID-19 shock. With increased vaccination rates and slowly opening economies, we’re seeing improved growth prospects.
Bank of Canada’s expected interest rate hikes in 2022
Several major central banks have either stopped, or announced the end of, their respective quantitative easing programs. Now, they’re talking about increasing bank rates with a two-pronged goal of normalizing rates and easing potential inflationary pressure.
Figure 1 shows changes in the market’s expected rate hikes from various central banks. As of September 30, 2021, it was expected that the Bank of Canada would raise the bank rate once in mid 2022. However, as of November 30, 2021, that expectation increased to four times throughout 2022, starting in March.
Figure 1: Forecast of Bank Rate Hikes for 2022
Source: Bloomberg
What rising rates mean for fixed income investments
While it’s clear that the market is expecting rate hikes this year, it’s surprising to see how much expectations have changed in just two months. We’re also seeing surprises in COVID-19 variants, as well as where and when the latest inflationary pressures emerge. So, it’s reasonable to expect bank rates to rise in 2022, and for there to be a lot of to-ing and fro-ing in expectations as we progress through the coming year.
What does this mean for fixed income investments in the coming year? Rising yields are a headwind for bonds, as was evident in 2021, but we don’t expect as bad a year for 2022. In fact, we could see a modest positive return and there are actions we can take to position portfolios for success in the current environment.
How investors can position themselves for success:
- Hold bonds with a lower exposure to interest rate movements. Bonds with shorter time to maturity fit this bill. A lot of our Canada bonds have short time to maturity.
- Hold bonds with higher coupon income. Corporate and Provincial bonds offer higher returns relative to a Canada bond of the same term. This extra return compensates for higher risk. Of course, we’re expecting a growing economy suggesting that the payment or default risks should be lower this coming year. We are over exposed to Corporate and Provincial bonds.
- Hold floating rate securities that take advantage of rising interest rates. Floating rate bonds have very little interest rate exposure. The coupon floats along with the bank rate. These can also protect a fixed income portfolio in a rising rate environment.
- Reinvest coupon income. There’s a small benefit that comes from reinvestment. Coupon income flows into the bond portfolio at regular intervals. As the market yields are rising, this coupon income can be reinvested at higher expected returns.
Volatility should be expected during the coming year as investors struggle to understand the ultimate effects of COVID-19, the extent and permanence of inflation, differential economic growth rates through out the world, and the impact of various geopolitical factors. In a more volatile market, there’s the potential for more short-term mis-pricing opportunities to emerge. This increases the potential to add a little extra return at the margin.