Pensions Prepare for a Rate Hike

kid-reaching-upInvestors will be watching closely as speculation ramps up that Canada’s central bank will raise interest rates by 25 basis points on Wednesday.

A modest increase won’t lead to a significant impact on the market in the short term because it has already reacted to the expectations of rising rates in the past few weeks, says Andrew Torres, ‎managing partner and chief executive officer at Lawrence Park Asset Management.

Torres notes institutional investors have been expecting the move after seeing the Canadian dollar strengthen recently. “We’ve seen a fairly substantial backup in the bond market in the last couple of weeks,” he says.

“We have been seeing bond yields rising, so you can read that as institutional investors have been preparing for the Bank of Canada rate. They’ve been reducing their bond holdings, which has pushed yields higher.”

In fact, yield curves for short-term Canadian bonds are already back to where they were before the central bank cut interest rates in 2015 in response to the country’s weakened economy, says Cameron Greenwood, vice-president and portfolio manager for fixed income at Foyston Gordon & Payne Inc. “So for the front end of the curve, we’re not expecting much of a move or reaction.”

What will be more surprising is if the central bank stays put and doesn’t make a change, says Greenwood, noting that would likely lead to a drop in bond yields.

But if interest rates do rise, investors will be wondering whether the central bank plans to make further increases in the future, says Torres.

“What happens next depends on whether [governor Stephen] Poloz and the Bank of Canada send further signals that they perceive a risk of inflation and that they want to hike rates even further,” he says. “At the moment, we’re not seeing that. All we’re seeing is they’re looking to correct interest rates to a moderately higher level, and bond yields have adjusted to reflect that.”

But if interest rates do continue to rise, investor behaviour will likely change when it comes to portfolio construction, says Greenwood. “Those investors with longer-dated liabilities, like pension funds and insurance companies, those type of investors get a little bit of relief on the liability side but may also look to switch their asset mix. Again, if interest rates move high enough, they may look to move out of equities and into fixed income-type products.”

However, such a switch would depend on pension plans’ solvency ratio and liabilities, says Greenwood, noting that if they do make a move, it would likely happen years later.

But despite the recent optimism about the Canadian economy, many investors are looking for alternatives to traditional fixed income as they remain leery of interest rate volatility, says Greenwood.

“Preferred shares are something [investors] have been taking advantage of in the last year and a half where the risk-reward perspective is more favourable than in this uncertain environment,” he says.

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