Interest rates are on the rise. This year, the Bank of Canada has raised rates by 50 basis points. And as the economy continues to continues to show signs of improvement, rates should continue to rise. But what does that mean when you’re saving for retirement?
While financial institutions have passed along the rate increases to borrowers, the interest rate on savings accounts and GICs have barely increased or not at all. That’s because financial institutions are under no obligation to increase rates on all of their products.
But if rates continue to rise, it can affect other investments in your portfolio.
As interest rates rise, so should the yield on newly issued bonds. But that can have a negative effect on the price of bonds you own.
Let’s assume you’ve recently bought a bond maturing in one year with a 2% yield for $1,000. The price won’t always stay the same as long as you own it, but the price will be more likely to decrease if interest rates rise.
If interest rates increase and one-year bonds are issued with a 3% yield, the price of your bond with a 2% yield will probably fall below $1,000. That’s because investors can now get the same type of bond but with a better yield. They won’t want to pay $1,000 for a bond with a 2% yield when they can pay the same price and get a 3% yield.
However, these price fluctuations won’t have as much of an impact if you hold the bond until it matures because you’ll receive 100% of its original value.
The stock market tends to rise when rate increases are caused by improved economic growth. And corporate earnings often improve when the economy is strong and the unemployment rate declines.
But if interest rates rise soar or if valuations on stocks continue to rise, it’s possible that bonds may become a more popular investment choice. As a result, investors will be more likely to allocate a greater portion of their portfolio to bonds than stocks.
However, certain stocks might outperform others in a rising rate environment. Growth stocks will be more likely to perform better than those with slower earnings growth.
The bottom line
As interest rates rise, you should monitor your retirement portfolio and make any adjustments you think are necessary. That may involve increasing your allocation to growth stocks or bonds, or doing nothing at all. Whatever you choose to do, you should ensure you have a well diversified portfolio.
Even though the 2017 RRSP deadline isn’t until early next year (March 1, 2018), it’s always good to contribute to your RRSP as soon as possible. By making an RRSP contribution early, your investments will have more time to grow and you’ll also benefit from tax-sheltered growth.
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