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By Christopher Davis |

Morningstar Minute - The impact of rising interest rates

Bond prices have fallen and may continue to do so, but investors should not abandon them.

The Bank of Canada raised interest rates for the first time in seven years, hiking them by a quarter of a percentage point. Canadians consumers will feel the pinch in their pocket books with higher mortgage and credit card rates. But how will it impact investors?

In the short-term, at least, rising interest rates are a negative for income-paying investments like bonds. When yields go up, bond prices go down. That is because the price of an already-issued bond must fall to compete with rival investments that--thanks to higher interest rates--now offer more-attractive yields. As a result, funds holding a portfolio of bonds take a hit. That's what's happened recently as Canadian investors have anticipated higher interest rates. For instance, the typical Canadian Fixed-Income fund has fallen nearly 2% over the past two months. The Bank of Canada has hinted that there may be further rate hikes to come, which could result in more volatility.

As unappealing as that sounds, this isn't a reason for investors to abandon bonds. For one, interest rates are notoriously difficult to forecast. In anticipating higher rates--wrongly--for most of this decade, the typical active bond fund managers has gotten it wrong. Two, higher rates necessarily bad. The Bank of Canada cited strong economic growth as the reason for its move. A healthy economy is a plus for much of the bond market, and is usually good news for other investments in a portfolio like stocks. Finally, bonds provide ballast to your portfolio in an equity bear market. In fact, in the worst 10% of Canadian equity market declines over the past 20 years, the TSX Composite Index fell 8%, while the FTSE/TMX Canada Universe Bond index rose 0.5%.

This isn't to say investors should expect much from bonds. Even after the Bank of Canada's recent move, bond yields remain near generational lows. Yields make up the better part of bond returns, so bond investors are mathematically doomed to modest performance. That's a reality we all must live with.

For Morningstar, I'm Christopher Davis.

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