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How to ride escalating interest rates

And now for the good news about the looming runup in interest rates.

If you're choking on the low returns available from bonds and guaranteed investment certificates, relief is coming. Want to be ready for it? Money market funds are an ideal vehicle.

Money market funds have been criticized a fair bit in this column over the past year for a couple of reasons. Their fees tend to be high - way too high in many cases - and some were caught out for holding a kind of security associated with the financial market upheaval that began last summer.

Also, Canadians are overreliant on money market funds as a safe parking spot for their investment dollars. A report issued last week by CIBC World Markets said people are sitting on a record $45-billion in cash that would normally be invested in the markets, much of it held in money market funds. In CIBC's estimation, this could be costing investors billions of dollars in gains from the market.

Still, money market funds have their uses. Like, for example, if you're waiting for interest rates to rise.

A well-chosen money market fund is like riding an interest rate escalator. As rates move up, the return on your money market fund gradually ratchets higher, too. You won't ride this escalator indefinitely, though. After rates rise, you'll cash out of your money market fund and move into bonds and GICs.

Short term, the outlook is for lower interest rates. The next Bank of Canada rate announcement is scheduled for June 10 and it's thought that the trendsetting overnight rate may come down another quarter of a percentage point. The overnight rate has already come down 1.5 points since last fall, and this has set a definite downward pattern for rates.

It's a pattern that has almost run its course. Inflation is far from dead and, while no one is predicting runaway price increases, there is a growing sense that the Bank of Canada will need to take action through rate increases. By one bank's forecast, rates will rise by a full percentage point next year.

The price of bonds and bond funds in your portfolio will fall as rates rise, but this is no big deal if you own them for the right reason, which is to generate income that smoothes the gyrations in your returns from the stock market. Anyway, rising rates would give you a chance to put new money into GICs and bonds with higher yields. Remember, falling prices for bonds means their yields are on the rise.

Your choice of money market fund is crucial to getting the most out of this rising-rate strategy. Only low-fee funds will do.

Money market funds all hold short-term bonds and corporate borrowings that mature in up to 90 days on average. Some funds tilt toward supersafe, lower-yielding government Treasury bills, while others mix in somewhat riskier and higher-paying corporate paper. But the bottom line is that these funds all hold largely the same stuff, with the prime differentiator being their fees.

The no-load Phillips Hager & North Canadian Money Market Fund (the class A version) has a very small management expense ratio of 0.49 per cent and its current yield is 3.3 per cent. The current yield is an annualized number based on the fund's returns in the previous seven days. CIBC Money Market has fees of 1.16 per cent and its current yield is 2.6 per cent. Notice the similarity between the MER differential on these two funds and the gap between their current yields?

By the way, you don't have to worry about money market funds holding any of that contaminated class of securities called asset-backed commercial paper. A small number held some ABCP, but independent fund analyst Dan Hallett says he believes that virtually all of these funds have rid themselves of these holdings.

High-interest savings accounts are a viable alternative to money market funds for parking cash, but only a few of them can be integrated into your investment portfolio. Two examples are the High-Interest CashPerformer from Altamira Investment Services, and the Dundee Investment Savings Account from Dundee Bank of Canada. Don't buy either without first asking your investment dealer or adviser whether purchase or redemption fees apply.

How will you know when the time is right to put the cash in your money market fund or high-interest account into bonds and GICs? A look back at rates over the past year offers some clues.

Last summer and into the fall, you could have nailed a five-year GIC at 5 per cent at some credit unions, alternative banks and trust companies, and maybe at a major bank if you succeeded in negotiating a major rate bonus. By the standards of the past 10 years or so, a 5-per-cent rate of return on a nearly risk-free investment is a deal. If it comes available, jump on it.

Quick picks: money market funds

Here are five low-fee money market funds suitable for parking funds you want to invest in bonds and GICs when interest rates rise.

FundMER (%)Current yield (%)Minimum investment
PH&N Cdn Money Market-A0.493.3$5,000
Mackenzie Sentinel Cash Mgt0.532.9$500
Saxon Money Market0.533$5,000
McLean Budden Money Market0.553$10,000
Altamira T-Bill0.632.5$1,000
Category average1.07



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