By Portfolio Solutions Group | Feb. 5, 2024
In this series of articles, Portfolio Solutions Group (PSG) discusses some of the fundamentals of investing and how they contribute to PSG performance. Discover how PSG approaches bond investing in their funds during time of interest rate fluctuations.
What happens to bond fund returns in general if rates decrease? What about guaranteed investment certificate (GICs) and high interest savings accounts?
A bond’s return is made of changes in the bond’s price and coupon payments. One of the biggest drivers of bond price returns is changes in prevailing interest rates. If interest rates decrease, prices of bonds increase, increasing the overall return.
To approximate the total return of the bond over a one-year period, we can estimate the price movement due to change of interest rates and add the yield of the bond as a proxy of the bond’s coupon payment.
If we assume interest rates to go up the same amount across the board, the estimated price change can be found by multiplying the fund’s duration by the change in interest rates. To calculate the estimated total return, you add the yield.
For example, if we look at a sample bond fund that holds a diversified basket of bonds with varying maturity dates, with a duration of seven years and yield of 5% and propose that all interest rates decrease by 1%, the bonds price is expected to increase by 7%. The overall return from the bond fund (in a year) would be a 7% price increase plus the 5% yield of the bond, for example, 7% + 5% = 12% overall return. Note: parallel shifts in interest rates rarely occur.
In the following example with varying levels of changes, the estimated total returns over a one-year period would be as follows:
Estimated total return over one year period:
|
Interest rate is increased by 1.0% |
-2.0%
|
|
Interest rate is increased by 0.5% |
1.5%
|
|
Interest rate is unchanged |
5.0%
|
|
Interest rate is decreased by 0.5% |
8.5%
|
|
Interest rate is decreased by 1.0% |
12.0% |
GICs’ annual total returns are composed solely of the income earned as determined by the interest rate at time of purchase.
The interest rate on high interest savings accounts is typically influenced by changes in the Bank of Canada’s overnight rate and would likely drop in the event of rate decreases. The annual total return of the high interest saving account is the aggregate of the variable rates earned over a one-year period.
Looking for more insights about the fundamentals of investing? Check out PSG back to basics series: What happened to bond investing in 2023?
Unlike mutual funds, the returns and principal of GICs are guaranteed.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. A description of the key features of the segregated fund policy is contained in the information folder. Any amount allocated to a segregated fund is invested at the risk of the policyowner and may increase or decrease in value.
The views expressed in this commentary are those of Portfolio Solutions Group as of February 5, 2024 and are subject to change without notice. Portfolio Solution Group (PSG) is a division of Canada Life Investment Management Ltd. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice.
Canada Life and design, Canada Life Investment Management and design, and other marks followed by the TM symbol at first time of use are trademarks of The Canada Life Assurance Company (“Canada Life”). Other marks displayed in this piece are trademarks of a third party, and used with permission or under license. Canada Life Investment Management Ltd. is a subsidiary of Canada Life.