Is your fixed income broken?
The starting yield on this year’s series of Canada Savings Bonds is – get this – 0.5 per cent for one year. If you’re willing to commit your hard-earned dollars to Ottawa for three years, you will be rewarded with a measly 1.19 per cent annually.
It’s a sign of the times as central banks around the developed world attempt to keep cheap money flowing by holding interest rates at rock-bottom. As a result, a typical Canadian bank GIC (guaranteed investment certificate) is returning 2.5 per cent to 3 per cent annually, and short-term government of Canada bonds are lingering at 3 per cent. With the outlook for the global economy worsening, the premium for holding longer term bonds is even shrinking.
If that wasn’t enough of a burden for investors trying to make a buck on the fixed-income portion of their portfolios, the annual inflation rate in Canada is looming at 3 per cent.
“It’s not easy to overcome inflation with these kinds of rates,” says Vancouver-based KCM Wealth Management president and chief investment officer Adrian Mastracci. “You just have to accept the fact that there’s not going to be a lot of yield.”
The 40-year-veteran financial planner has been reminding his clients that the first priority of a fixed income portfolio is to act as a stabilizer to the normally volatile equity portion of the entire portfolio – regardless of yield. It’s supposed to be the part of your portfolio that lets you sleep at night. Traditionally, that means buying and holding bonds to maturity as part of strategy known as laddering – staggering maturities over a period of years to create frequent opportunities to reinvest at the best going rates.
“We always use a laddering strategy not matter what,” he says, suggesting a length of five years in this interest-rate environment.
But just trying to keep ahead of inflation isn’t enough for investors – particularly retired investors – who rely on income for day-to-day living. As a general rule, the only way to get a higher return on fixed income is to increase risk. Mr. Mastracci says that higher level of risk can be minimized through a diversified mix of corporate bonds (from investment grade to high yield junk bonds), bond mutual funds, exchange trade bond funds, preferred shares, real estate investment trusts (REITs) and dividend stocks such as utility companies with consistent and reliable cash flows. “You can buy the lesser quality bonds with higher yield but your money may not come back totally,” he says.
That added risk is quickly becoming a fact of life for retail investors and is making fixed income much less fixed. Income-generating securities, such as bond funds and dividend stocks, have the potential to go down in value.
In the past, financial advisers such as Mr. Mastracci recommended 40 per cent to 60 per cent of all assets in an individual portfolio be held in fixed income and the rest in equities, but in the new reality, the line between fixed income and equity has become blurred.
“It’s not fair to call it fixed income and it’s not fair to call it equity because you’re still getting an income,” he says. “I would arbitrarily split them in half and anyone else out there can split it whichever way they want.”
Bond trader and senior vice president at Toronto-based Ridgewood Capital Asset Management Mark Carpani deals with the challenge of keeping returns ahead of inflation every day. Institutional money managers such as Ridgewood make their money by investing large sums of capital to take advantage of tiny discrepancies, or spreads, between debt instruments.
Mr. Carpani says the only alternative for retail investors who rely on fixed-income for retirement is to move out of their sleep-at-night, top grade bonds. “They will have to stretch a bit out of their comfort zone with regard to risk,” he says.
He says those investors who don’t have the risk appetite for junk bonds can still return 4 per cent to 6 per cent in this interest-rate environment, provided their fixed-income portfolio is well-diversified and properly laddered. “They won’t take a loss. They will just clip their coupon, get their income and either use the money or roll it over if they don’t need it.”
He suggests investors look to exchange traded funds. The iShares family offers two high-yield ETFs – one in U.S. dollars under the symbol HYG, and another hedged to the Canadian dollar under the symbol XHY. Claymore also offers a Canadian traded high-yield bond ETF with the symbol CHB.
Any fixed-income instrument carries the risk of becoming devalued if inflation rises. To protect against increases in the cost of living, investors can purchase real-return bonds, which are adjusted to compensate for increases in inflation. That sort of safety has a price in the form of lower yields – a price that Mr. Carpani says is not worth paying. “We’re not bulls on inflation so we don’t think real return bonds are what you want.”
Regardless, the threat of inflation persists, as witnessed by recent swings in the price of commodities such as oil, metals and food. If that happens, central banks will have little choice but to tighten money supply by raising their benchmark rates. As interest rates rise, bond yields rise and that diminishes the value of existing bonds paying lower rates. Major central banks in Europe, the United States and Canada have gone on record saying there is a very low probability of rate hikes for at least two years.
Ridgewood says it may take a little less time for an increase, but when it happens, it will be small. “We expect a low interest rate environment for a number of years,” says Mr. Carpani.