Wealth

How Investors Can Prepare for Rising Interest Rates

By Nest Wealth on 07/02/2019Article 5 Minute Read

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By: Penelope Graham, Zoocasa

Whether or not interest rates will rise is always a top concern for Canadian mortgage borrowers and investors – and many economists expect multiple hikes are coming in 2019.

That’s because the Bank of Canada (BoC), the central institution that sets the Prime cost of borrowing for consumer lenders, has revealed it intends to increase its trend-setting Overnight Lending Rate to a “neutral” range between 2.5 – 3.5%. That’s a hefty jump from the current 1.75% and will likely cause sticker shock for many Canadians, especially as rates have been historically low since the 2008 recession.

As interest rates for variable mortgages and lines of credit are directly influenced by the BoC, those borrowers immediately face higher monthly payments or less of those payments going to their principal debt. However, whether or not the BoC cuts or hikes rates has implications for all types of investments, even savings vehicles with passive earnings. Here’s what investors should keep an eye out for as the 2019 rate announcement lineup kicks off.

The Bond Market

Those holding government bonds pay very close attention to BoC announcements, and for good reason: rate cuts immediately improve the value of their investments, while hikes devalue them.

This is largely based on the size of the bond’s coupon, the rate of interest that a bond pays annually. When interest rates rise, so too does the coupon on newly-issued bonds. Those holding existing bonds face a conundrum, as their asset now has a smaller coupon than the market standard. On the flipside, interest rate cuts boost the competitiveness of existing bonds, as they now boast a return higher than fresh bonds coming to market.

Lower bond yields also pose an advantage to fixed-rate mortgage holders; when coupons are lower, lenders tend to pass the savings down to their fixed mortgage products; for this reason, it’s very advantageous for borrowers to apply for, or renew, their fixed-rate mortgages during a lower interest rate environment.

Stocks

Interest rates are hardly just a consumer concern – after all, businesses are the biggest borrowers around. When the cost of borrowing rises for companies, that puts the squeeze on their bottom lines, and in turn introduces risk for their equity holders. A public corporation facing steeper interest rates may dedicate more of its earnings to debt repayment rather than growth, new capital, or innovation – not to mention dividends for its stockholders.

Bank stocks, in particular, tend to be hardest hit, as higher interest rates often translate into fewer consumer loans and mortgages on the books. This development has already started to unfold, as the Canada Mortgage and Housing Corporation reported 11.9% fewer new mortgages in its most recent quarterly report – that’s 205,000 loans, and a direct impact on banks’ profit margins.

Prime-Linked Savings

Because Canada’s lenders use the BoC’s rate to set their own Prime rate, savings vehicles with market exposure will see their returns fluctuate alongside the Overnight Lending Rate.

For example, investors with funds locked into variable-rate Guaranteed Investment Certificates (GICs) could see the size of their payout drop or increase over the term of their investment (though variable GICs still tend to outperform the fixed-rate variety over time during rising rate environments).

Rate changes will also marginally impact the amount that’s earned on funds kept in a high-interest savings account (HISA), though lenders tend to be much quicker to slash returns after a rate cut than when it’s the other way around.

Real Estate

While the BoC’s rate trends have immediate implications for mortgage borrowers, from a historical standpoint they tend not to directly heat or cool housing markets. Real estate investors, especially those in hot markets like the Greater Toronto Area and Vancouver real estate, are generally more concerned with supply and demand imbalances, and how they may impact property values.

However, the five hikes mandated by the BoC since July 2017 have had a harder impact on home buyers than before, as they’re now hit with the double whammy of higher interest rates and a new federal mortgage stress test. Introduced one year ago as a measure to reduce risky borrowing practices, this stress test requires new mortgage borrowers to prove they could still afford their mortgage should rates rise, and qualifies them at a benchmark roughly 2% higher than the one they’ll get from their bank.

That’s chopped purchasing power for many buyers and has knocked others out of the market altogether, chilling sales in some of the nation’s smaller urban and rural centres – for example, demand for Calgary homes for sale, which saw sales drop 14% over 2018. However, larger markets have started to feel the brunt of fewer buyers: Toronto sales fell nearly 15% in November, while the Greater Vancouver region has seen whopping declines of 42.5%.

With more hikes potentially on 2019’s horizon , anyone planning to get a mortgage this year will likely see this threshold steepen, eventually negatively impacting prices – and investors’ bottom lines.

 

Penelope Graham is the Managing Editor of Zoocasa.com, a real estate website that combines online search tools and a full-service brokerage to let Canadians purchase or sell their homes faster, easier and more successfully. Home buyers and sellers can browse listings on the site, or with Zoocasa’s free iOs app.