Interest rates are rising again. The last hike cycle offers clues on what lies ahead
There are strategies to protect your money when the Bank of Canada hikes rates
Last week, the Bank of Canada hiked its benchmark interest rate for the first time in three years, from 2.25 per cent to 2.5 per cent, raising the collective blood pressure of Canadians.
We’ve seen this cycle before. In 2022, central banks began hiking interest rates to combat surging inflation caused by the pandemic and later the war in Ukraine. Younger generations were caught off guard, having never seen interest rates rise this quickly before.
Today, once again, inflation is running too hot, but this time it’s caused by U.S. tariffs and the war in Iran.
So, let’s review what went up, what went down, and what got crushed during that tumultuous period of 2022 and 2023, when the benchmark policy rate shot from 0.25 per cent to 5 per cent.
Variable-rate mortgage holders got crushed
Anyone who didn’t understand the relationship between interest rates and real estate got a very painful education during the last round of hikes.
The buyers who felt the most pain were those who purchased a property when interest rates were at their lowest using a variable-rate mortgage.
Variable-rate mortgages arebased on the bank’s prime rate, which is directly tied to the Bank of Canada’s benchmark rate. When rates go up, the interest on your mortgage goes up with it, likely along with your monthly payments.
The lesson is clear. If you have a variable-rate mortgage, now’s the time to consider switching to a fixed-rate mortgage or, if possible, to aggressively pay it off.
Bond holders lost money
Bonds are meant to be a safe investment and, traditionally, when stock markets dive, bonds are supposed to rise. But that didn’t happen in 2022. Why?
Bonds move in the opposite direction of interest rates. This is because rising interest rates mean that new bonds being issued will pay a higher rate than existing bonds, which makes those existing bonds comparatively less attractive.
This is when bond duration becomes important.
Duration is a measure of how sensitive a bond fund is to interest rate changes, and is usually published in a fund’s prospectus. For example, the iShares Core Canadian Universe Bond Index ETF (XBB-T) currently has a duration of 6.7. This means that if bond yields rise 1 per cent, XBB can be expected to fall in price by around 6.7 per cent.
That’s why in a rising interest rate environment, it makes sense to shorten the duration of your bond holdings by using a short-term bond fund like the iShares Core Canadian Short Term Bond Index ETF (XSB-T), which has a duration of just 2.8. This way, if yields rise 1 per cent, XSB will fall by around 2.8 per cent.
Money market funds performed surprisingly well
What if we dropped duration all the way down to zero? That’s where money market funds come in.
Money market funds are essentially zero-duration bonds. The maturities of the securities they hold are so short that they essentially don’t change in price when interest rates rise. When interest rates climb, the amount of interest they pay also goes up because the fund acquires new, higher-yielding securities to replace the ones that mature on a rotating basis.
The result during the last interest rate hike cycle? A surprisingly stable type of fund with payouts that went up.
Floating rate notes also did well
Floating rate notes (FRNs) are basically the variable-rate mortgage equivalent of the bond world. Instead of paying a fixed interest rate like regular bonds, FRNs pay a floating interest rate. When interest rates go up, their coupon payment goes up as well, so you get a raise while the fund’s price stays relatively steady.
If we plot out how these assets behaved during the tumultuous interest rate period between the first quarter of 2022 and the third quarter of 2023, we can see how they compared to other types of funds.
An aggregate bond index like XBB fell -11.8 per cent, which is pretty dramatic for a bond fund. A short-term bond fund like XSB still fell, but much less at -3 per cent. Money market funds like the BMO Money Market Fund ETF Series (ZMMK-T) gained 5.6 per cent, and floating rate note funds like the iShares Floating Rate Index ETF (XFR-T) gained 5.8 per cent.
While 2026 is not the same as 2022, if interest rates continue to climb, paying down a variable-rate mortgage, shortening your bond durations and owning floating rate notes are some strategies you can use to protect your money.
Bryce Leung and Kristy Shen are early retirees and co-authors of Parent Like a Millionaire (Without Being One)