Will interest rates begin their ascent Thursday at 2 pm Eastern?
Beats me. But it’s really a moot point. If not tomorrow, it will be next month. Have no doubt. It’s coming. Pulling the trigger will be the US central bank, known as the Fed. It’s been waiting for months for the right moment when the economy is strong enough to withstand money getting a little more expensive. This may be it.
Now, most importantly, how can you benefit?
Well, not buying a beater house on a crappy street in downtown Toronto or Vancouver would be a fine start. This first rate hike will be one of many (the Fed usually increases about a dozen times during a tightening cycle), so you can count on higher mortgages and lower real estate. As I mentioned earlier this week, there’s a 93% chance Canadian rates will follow those in the US, albeit after a lag. If you want to battle those odds, knock yourself out.
Beyond that, you should consider loading up on some preferred shares. Two reasons: (a) they’ll benefit from rising rates and (b) they’re cheap. Like Kias, but actually worth buying.
Just so you’re clear – preferreds are kinda like stocks and sorta like bonds. They’re considered ‘fixed income’ like bonds and are far less volatile than common stocks, but they pay dividends instead of interest. That’s great because interest is taxed to the max while dividends come with a tax credit – so the after-tax return is much higher. Also while bonds pay extremely little these days (about as exciting as a savings account with the jam people), preferreds have been returning yields in the 5% range. Sweet.
Also preferreds are called ‘preferred’ because they’re, well, preferred. Special. Companies issuing them must pay the dividends on preferreds before they pay out on common stock, so the income stream is safer. (Not that this matters if you buy the prefs of stable companies like banks, insurers or utilities.)
All good. But, like bonds, the capital value of preferreds is influenced by interest rates. So when the dingalings at the Bank of Canada cut the key rate there in January and again in July, preferred share prices went down along with bond yields. This was despite the fact these puppies keep churning out that 5% tax-advantaged yield. So in terms of valuations, preferreds have sucked in 2015, losing about 17% of their value.
Why would you buy them?
Simple. This cheapness will not last, and preferreds are poised to be among the significant winners as interest rates start the long trip back to normal. A bunch of smart people believe the values of prefs will rise by at least 10% in 2016, possibly more, making them star assets just a year after being dogs.
Most preferred shares are called “rate reset”, which means they’re tied to the five-year Government of Canada bond – the one which our central bank bombed with its rate cuts. Now that the US Fed’s changing the game, and because our market almost always follows theirs, you can expect Canadian bond yields will be plumping for months to come. In fact, yields have already crept higher, with big moves possible after Thursday’s announcement.
Higher bond yields are positive for preferred share prices, so given the fact these cost almost 20% less than a year ago and have big upside it begs the question: why would you not have some? Especially when they pay a 5% return just for owning them and that money’s not sucked off in tax like interest from a dead-end GIC?
Prefs aren’t popular because TNL@TB doesn’t sell them at the corner branch. No worries. There are a bunch of good ETFs around that contain a basket of high-quality Canadian preferreds issued by big, stable companies – including the same banks that won’t sell them to you over the counter.
Preferred shares, in short, offer one of the best protections around against rising interest rates – which stand to do serious damage to real estate and may also usher in more equity market gyrations. So, you can moan, cringe and deny like most of the people who come to this pathetic blog to say rates will never, ever go up. Or, you can get ready for reality, and let central banks grow your net worth a little.
Now, how hard was that?