Interest rates are rising in the U.S. and Canada. That brings opportunity to those putting money into savings accounts and guaranteed income certificates, but also pressure on those who borrow. Global politics, trade negotiations and the sheer risk of investing are separating returns on investments from the cost of borrowing. Trend setting government bond interest rates have zoomed up from lows in early 2016 with the result that banks pay depositors a little more but borrowers have to pay banks and other lenders a lot more.
In the U.S., the strength of the economic recovery — enhanced, some say, by President Trump’s tax cuts — has accelerated the rise in interest rates. The Federal Reserve Board is expected to raise its critical short rate three times in 2018 — some observers say four. A fourth raise would put the critical overnight rate — the rate banks pay to borrow reserves from the central bank — at about 2.875 per cent, more than twice the present 1.375 per cent overnight rate. In Canada, one more raise from the present 1.25 per cent to 2.0 per cent by the end of 2019 is expected, says Royce Mendes, director and senior economist at the capital markets division of CIBC in Toronto.
The combination of recovery in the U.S., a potential trade war with Canada over steel and aluminum, geopolitical jitters triggered by threats of nuclear war with North Korea, and the unknown durability of the incumbent president and his policies have pushed U.S. and Canadian yield curves into a swamp of risk. Where the risk lies depends on whether you are borrowing or investing.
Borrowers and investors
From a Canadian homebuyer’s point of view, current mortgage rates range from 2.69 per cent for a one-year term with a floating rate, to 3.04 per cent for a five-year fixed term, to 3.84 per cent for a 10-year fixed term.
Canadian borrowers tend to seek security. Thus five-year closed mortgages at 3.04 per cent tend to be more popular than the floating rate five-year mortgage currently at 2.21 per cent. Clearly, buying peace of mind is worthwhile to some borrowers.
But the cost on a 30-year mortgage is substantial. For a $500,000 loan, the 2.21 per cent rate costs $1,901 per month; the 3.04 per cent mortgage costs $2,118 per month. Leaving out variations in amortization (the cheaper mortgage pays off the loan balance faster), the difference in rates amounts to a $78,120 difference in total mortgage outlay. For more information on the cost of peace of mind, visit www.ratehub.ca/best-mortgage-rates.
For investors who want to lock in returns, the differences between borrowing and lending are striking. The annual yield to maturity on a Government of Canada 10-year bond, 2.17 per cent, just 16 basis points less than the 2.33 per cent average annual yield to maturity on a 30-year Government of Canada bond. In other words, for a 20-year $10,000 bond, the annual premium one gets for locking up money for 20 more years over a 10-year bond is just $16. That’s chump change.
Corporate bonds have more risk than government bonds. Canada’s corporate bond market does not yet reflect the potential effects of trade wars, the chance of a U.S.-caused economic slowdown or sheer uncertainty.
“Bonds do not reflect event risk, but those are mostly one-off events, such as problems with North Korea,” explains Chris Kresic, partner and head of fixed income at Jarislowsky Fraser Ltd. in Toronto. “Corporate bond prices are higher and yields lower than they would be if geopolitical and other risks were priced in. Growth and inflation are more important drivers of return.”
The question for the fixed income investor, who will get back only the amount of money in a bond if it’s held to maturity plus interest, is whether promised returns are appropriate for the political risk rocking the stock market.
Fixed income markets for bonds and GICs are pricing in inflation but not geopolitical risk. On down days, global stock markets are offering bargains. There is no default risk in the federal bonds of Canada and the U.S., but paying the list price for bonds when you can buy them at nice discounts of a fraction of one per cent of yield is just unnecessary. Talk to a financial advisor if this stuff is not part of your toolkit.