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What do high interest rates mean for retirement savings?

February 1, 2023
What do high interest rates mean for retirement savings?

This article originally appeared on Moneysense.ca and has been published here with permission.

The Bank of Canada embarked on a series of interest rate hikes last year, taking its trendsetting policy rate from 0.25% all the way to 4.5%, in an effort to stamp out what has become persistently high inflation. The central bank has signalled that rate hikes will continue or stay elevated until morale improves—as in, until we see a meaningful and sustained drop in inflation.

This abrupt shift marked the end of more than a decade of low interest rates. So, what do rising interest rates mean for retirement planning? There’s good and bad news.

Let’s start with the bad news.

Rising interest and your investment portfolio

A rising-interest-rate environment spells trouble for bonds, particularly bonds that have a longer duration. Canadian long-term bond returns fell 21.5% in 2022, while short-term bond returns fell just 3.85%. Aggregate bond returns (a mix of short-, medium- and long-duration bonds) fell 11.6%.

The good news is that if we’re near the top of this rate-hiking cycle, then bonds finally have some upside. How’s that? Well, if the economy tips into a recession or generally slows down, we may see bond yields fall and bond prices rise.

Stocks don’t perform well in a rising-rate environment either, as evidenced by the terrible performance of global stocks last year. Specifically, rising rates hurt technology stocks—the ones that benefited from more than a decade of low interest rates, which helped them fund their low-profit/high-growth years. Utility stocks and real estate investment trusts (REITs) also performed poorly in 2022.

On the other hand, energy, financials and consumer staples may perform better in a high-interest-rate environment. Regardless, a smart approach is to hold a slice of every stock through low-cost, globally diversified index funds or exchange-traded funds (ETFs).

Pros and cons of high interest rates

A high-interest-rate environment can benefit investors who have money to set aside in high-interest savings accounts (HISAs) and guaranteed investment certificates (GICs). We’ve seen a significant increase in high-interest savings rates, with several online banks and credit unions offering 3% or more as of mid-January 2023. GICs have seen a similar increase, with one- to five-year terms all available at 5% or higher.

Bonds yields have spiked, and while that’s bad for bond prices, it does mean that new bonds issued today actually offer a higher yield, meaning more interest in your pocket, plus some price upside if interest rates do indeed fall.

The downside to rising interest rates is how it can impact borrowers. Many Canadians are saddled with high debt with mortgages and lines of credit. Those with variable mortgage rates have already felt the sting of higher rates, while those fortunate enough to still hold a fixed-rate mortgage under 3% will face the prospect of renewing at much higher rates when their term expires.

What can investors do to protect their retirement savings now?

Young investors with a long-time horizon will likely benefit from staying the course with a sensible, risk-appropriate portfolio. In fact, those in their accumulation years should be elated that stock and bond prices have fallen significantly—it means they can purchase more shares at discounted prices.

For those in retirement or nearing retirement, the current environment can be more of a challenge. It’s a good time for investors to revisit their capacity for risk. The few years leading up to 2021 saw massive speculation in risky assets such as crypto, NFTs and meme stocks. Even the most disciplined investor may have strayed from their core portfolio due to FOMO. Then 2022 hit, and those risky assets saw the largest drawdowns. It’s a lesson to stay true to a risk-appropriate portfolio in good times and bad to avoid buying high and selling low.

Then there’s the question of bonds. Retirees and soon-to-be retirees got a shock last year when their bonds fell just as sharply as stocks. The lesson in a rising-rate environment is to hold shorter-duration bonds that are less sensitive to interest rate movements. Further to that, GICs and high-interest savings accounts finally offer decent yields of 3% to 5% interest—perfect for short-term spending needs and for queuing up expected withdrawals from RRIFs over the next one to five years.

Finally, many retired investors still hunger for yield and gravitate towards dividend stocks and ETFs, along with monthly income funds. More recently, ETFs with a covered call writing strategy, such as Harvest ETFs’ call option ETFs, have emerged to provide higher, tax-advantaged monthly income for those seeking higher yields.

What happens when interest rates fall again?

No one has a crystal ball, but with inflation starting to recede, there’s a growing sentiment that we’re at or near the top of this rate-hiking cycle. What happens next is anyone’s guess, but the clues will be in how quickly inflation gets tamped down and whether the central bank’s relentless pressure pushes the economy into a recession. If that happens, watch for interest rates to fall modestly to stimulate growth.

A drop in rates will be good news for bond holders as they look to recover their losses from 2022. The bad news for savers is that we’re likely at the high point of GIC and HISA interest rates. Watch for these to tick down when the Bank of Canada pauses or reduces its key lending rate.

What should investors do about inflation?

We should acknowledge that 2022 was an unusual year, one that saw double-digit declines in both stock and bond prices after a series of rapid interest rate hikes by central banks around the world.

Your retirement savings may have taken a beating last year, and you’re wondering what to do at the tail end of this rising-interest-rate environment.

A good investor sticks to their plan regardless of market conditions, but the increase in rates does provide opportunities to take advantage of higher bond yields, GICs and high-interest savings.

For more tactical investors, they may avoid the high-flying growth stocks that thrived in a low-rate environment and opt for blue-chip financial, energy and consumer staple stocks. And today’s yield-hungry investors may find their income from ETFs that focus on dividends, monthly income or covered call writing strategies.

Author:

Robb Engen

MoneySense Contributor

HDIF has paid high monthly cashflow to Canadian investors

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