FP Answers: Which investment strategies work best when interest rates are high?

By Julie Cazzin with Amar Pandya 

­­­Q: I think the economic tide has changed and this period of higher-than-average interest rates is here to stay. What types of investments, and which investment strategies, historically do well during these economic times? — Domenic M.

FP Answers: Domenic, you may be right about anticipating a period of higher-than-average interest rates though it helps to put the term “high” in historical context. Back in the 1970s, due to exogenous shocks such as the Organization of the Petroleum Exporting Countries’ oil embargo and global food shortages, inflation shot up, doubling to 10 per cent within a decade and hitting a peak of 12.9 per cent in 1981. To try to tamp down inflation, the Bank of Canada lifted interest rates to a high of 21 per cent at one point.

The world’s central banks are in a tricky spot: Do they allow inflation to run hot (above the two-per-cent target) with the risk of entrenching higher inflation in the economy, or do they keep raising interest rates to crush inflation and potentially trigger a recession?

For investors, the past 35 years of benign inflation have been a tailwind for most types of assets, including equities, bonds and real estate. Portfolios constructed during this disinflationary period may not be inflation-proofed for the new reality. For example, during 2022, bonds, which are usually considered as being lower risk and less volatile than stocks, became highly volatile and generated significant losses as interest rates rose. Rising inflation is also a headwind for equities.Historically, there have been investment strategies that outperform in a higher rate environment. These have included international stocks, commodities and certain kinds of real estate. Some may even consider cash in this bucket since rising interest rates are reflected in higher nominal returns for guaranteed investment certificates (GICs) and other term deposits.

Two investment strategies to consider with the aim of generating positive real returns are merger arbitrage and small-cap funds.

Merger arbitrage (sometimes called risk arbitrage) involves purchasing shares of a company targeted in a merger or acquisition. There is usually a price gap between the price offered by the suitor and the current price due to the risk of the deal not closing. A merger arbitrage strategy involves collecting the difference, or spread, between the offer/closing price and the current market price.

An allocation to this strategy would fit into the fixed-income portion of a balanced portfolio. Because merger arbitrage has a low correlation to bonds (and equities), it is a good diversifier in any portfolio. Another advantage is its tax efficiency because returns are taxed as capital gains, not interest income.

Small-cap stocks are another potential beneficiary of higher rates for several reasons. Smaller companies do not use as much leverage as larger ones, so they are less likely to be holding costly debt that becomes more expensive to manage as interest rates rise. They also tend to have higher growth rates and, while they can have larger drawdowns during a correction, they also tend to outperform in the aftermath.

Currently, the valuation gap between large-cap and small-cap companies is at a historical peak, which also bodes well for future returns for small caps. Small caps, comprising anywhere from five per cent to 30 per cent of the equity portion of a portfolio, could provide inflation-adjusted real returns over the long term.

As inflation remains sticky, investors should re-evaluate whether a traditional allocation to stocks and bonds (60/40) is still the best strategy for generating positive real returns and maintaining purchasing power over the long term.

Amar Pandya, CFA, is a portfolio manager of the Pender Alternative Arbitrage Fund, Pender Alternative Arbitrage Plus Fund, and Pender Alternative Special Situations Fund.