Rate cut presents planning opportunity
Managing net worth is key

The Bank of Canada recently cut its key overnight interest rate by a quarter of a percentage point, to 2.5 percent. Trends in consumer credit and investment flows indicate that consumers may be overexposing themselves to interest rate risk. This presents an opportunity to further diversify investment portfolios and individual balance sheets.

Retail trends

It's natural that consumers would assume higher debt loads as interest rates have fallen - as has happened over the past dozen years or so. As of the end of 2002, Canadians held approximately $700 billion in consumer credit and mortgage debt - a total rise in excess of 27 percent over the previous four years. Consumer credit usually carries a floating rate, while mortgage debt is increasingly held in the form of 'variable' or floating rate loans.

On the investment front, last week's article clearly documented the dominance of bond and income trust funds with respect to attracting new money from individual investors. Over the past two years, income funds lured more than $12 billion in new net sales, while all fund categories reported less than $4 billion in net sales.

In short, much of the current load of mortgage and consumer credit carry floating interest rates - usually moving in tandem with shorter-term rates. Depending on the specific exposure, income funds are generally sensitive to both short and long term rate changes.

It is this high exposure to interest rate risk - i.e. benefiting from low, falling rates - that has played a part in allowing Canadians to prosper for several years. However, there comes a point in time when investors and advisors must take action to reduce this exposure.

Net worth approach to investing

Several months ago, I wrote about Big Picture Investing or what I call the Net Worth approach to portfolio construction. Today is a perfect opportunity to put the approach to work.

Of the $439 billion in mutual fund assets tracked by the Investment Funds Institute of Canada (IFIC), close to 30 percent is held in bond, mortgage, and dividend funds. Interestingly, that's the highest level since the 1994-1995 period, which marked the period of (arguably) the worst year in the history of bond markets. I'm not suggesting that we're about to head into catastrophic times for bonds. However, it is important to take a close look at current risk exposures and ensure diversification of factor risks.

The recent drop in the overnight rate likely had a positive impact on both the mortgage and bond markets. After all, mortgage rates typically reflect bond market activity. With highly interest sensitive assets in many investment portfolios and similarly sensitive loans on their balance sheets, individual investors should think hard about acting now to immunize one of those pieces from an eventual rise in rates.

If fixed income is in the form of individual bonds, selling prior to maturity is costly. Plus, if held to maturity, some guarantees exist. That said, the fixed income portion of the portfolio could be protected somewhat by emphasizing real return bonds. Another option for taxable accounts is to search for floating rate preferred shares - or check for dividend funds holding such securities.

On the mortgage side, consider locking in mortgage rates. It's not uncommon to find five-year fixed mortgage rates below 5 percent. It just doesn't get much better than that.

Conclusion

Interest rates need not rise sharply in the next twelve months for this advice to pay off. This is not about making and profiting from short term forecasts, but rather about prudent risk control and reduction. When interest rates eventually turn upward, your (or your client's) net worth will not all be impacted in the same fashion. This partial immunization strategy will help to smooth out fluctuations in net worth the next time interest rates make a sustained move.