The end seems near. Short-term interest rates are normalizing and for investors that means rates are going up. The age of record low interest rates could be ending.
Central banks in Canada and the US have both increased their benchmark rates over the past year, and many market observers expect more hikes to come. In July, the Bank of Canada said it expects “higher interest rates will be warranted” to keep inflation near its target of 2%. Canada’s annual inflation rate increased to 2.5% in June as consumer prices rose at the fastest pace in more than six years, according to Statistics Canada.
Inflation and interest rates have been low since the global financial crisis of 2008, but some fixed-income securities could be negatively impacted if rates continue to go higher.
What options are available for income-seeking investors in a rising rate environment?
“When rates are increasing, advisors can’t be passive when it comes to their clients’ fixed income allocations. They can work with an experienced portfolio manager who can make decisions in areas like yield and duration, at a low cost,” said Ahmed Farooq, Vice President, ETF Business Development, at Franklin Templeton Investments Canada.
An actively managed fixed income ETF that can adjust interest payments according to rate changes can help mitigate interest rate risk. Floating-rate bank loans are not interest rate sensitive because they are short-term, responsive investments that pay interest that adjusts periodically to current rates. The benefit to investors is that as short-term rates go up, the interest payment from a floating rate bank loan also rises. Historically, bank loans have outperformed other fixed-income assets when rates were rising, as seen in the chart.
Bank Loans Offer Higher Return Potential During Periods of Rising Rates
Average Return During Periods of Rising Interest Rates (%)
December 1986-December 2017
Source: Morningstar Research Inc.*
An active ETF that invests in senior, secured floating-rate US bank loans is designed to maintain a predictable flow of income and “immunize” the bond portion of a portfolio against the impact of rising rates. As an added layer of protection, senior, secured bank loans are backed by collateral in case of default. Some ETFs also hedge returns to the Canadian dollar to guard against fluctuations in the US exchange rate.
“Bank loans have a record of providing floating-rate income with relatively low volatility because of their senior position in the capital structure and security provided by collateral in most cases,” said Mark Boyadjian, Portfolio Manager of Franklin Liberty Senior Loan ETF (CAD-Hedged)|TSX: FLSL.
Learn more about this and other Franklin LibertyShares® ETF strategies at franklintempleton.ca.
Commissions, management fees and expenses may all be associated with investments in ETFs. Investors should carefully consider an ETF’s investment objectives and strategies, risks, fees and expenses before investing. The prospectus and ETF facts contain this and other information. Please read the prospectus and ETF facts carefully before investing. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. Performance of an ETF may vary significantly from the performance of an index, as a result of transaction costs, expenses and other factors. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.
* All returns are based on indices’ base currency. Periods of rising/falling interest rated are defined as calendar years when rates on the ten-year U.S. Treasury rose/fell more than 100 basis points for the period from December 1986 to December 2017. Average returns for each asset class only include the years where data is available. Important data provider notices and term available at www.franklintempletondatasources.com. Bank Loans, Credit Suisse Leveraged Loan Index USD; Canadian Bond Universe, FTSE TMX Canada Universe Bond Index CAD; Canadian Corporate Bonds, FTSE TMX Canada All Corp Universe TR CAD; Canadian Government Bonds, FTSE TMX Canada Government Bond Index CAD; Canadian Provincial & Municipal Bonds, BofAML Canadian Provincials & Municipal Bonds TR CAD; Emerging Market Sovereign Debt, Bloomberg Barclays Emerging Market Debt TR USD; G7 Sovereign Debt, Bloomberg Barclays Global G7 TR; High Yield Bonds, Credit Suisse First Boston High Yield USD; Sovereigns, Citi World Government Bond Index USD; U.S. Corporate Bonds, Barclays Capital U.S. Credit TR USD; U.S. Government Bonds, Bloomberg Barclays U.S. Government TR USD; U.S. Mortgage-Backed Securities, Bloomberg Barclays U.S. MBS TR USD; U.S. Municipal Bonds, Bloomberg Barclays Municipal TR USD; U.S. T-Bills, Bloomberg Barclays U.S. Treasury Bills TR USD; U.S. TIPS, Barclays Capital U.S. Treasury Inflation Protected Securities TR USD. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.