Income-seeking investors face a dilemma. They need a steady yield that outpaces inflation, but that's no simple trick.
"Canadian government bonds, GICs and [Treasury] bills won't do the job," says certified financial planner Cynthia Kett, with Toronto-based Stewart & Kett Financial Advisers. These investments, the stalwarts of retirees and conservative savers, pay 2 per cent or less per year.
Once you add inflation to the mix – also about 2 per cent – and taxes, they are losing propositions.
Investors who nonetheless insist on sticking with these investments can face more risk than just watching their buying power erode. They also could see significant capital losses in their portfolio if inflation starts to ramp up.
Indeed, inflation is expected to rise this year and next, above the 2-per-cent target set by the Bank of Canada. Some forecasters, including the data provider Trading Economics, estimate inflation will reach 2.9 per cent by 2020. If that happens, investors can also expect interest rate hikes aimed at putting the brakes on rising prices.
That scenario likely will not bode well for investors holding bonds and income-focused equities, says Roland Chalupka, chief investment officer of Fiduciary Trust Canada.
"All of a sudden the capital value of bonds is decreasing, and the coupon payments may not be able to make up that value that's being lost," Mr. Chalupka says, "so the total return on a bond may actually be negative."
Equities may also be hit, Mr. Chalupka says. "Those companies that are not efficient operators are no longer subsidized to be in the market [by low borrowing costs], so rising rates over time can affect the stock market negatively, too."
Rising rates are generally bad news, at least initially, for the most sought-after, income-producing securities – preferred shares, utilities and real estate investment trusts (REITs). Because these businesses and investments are often highly leveraged, rate hikes increase their borrowing costs and eat into their ability to generate income for investors.
Still, rising inflation and rising interest rates are generally welcome conditions as "long as the economic pie is getting bigger and growth is spurred by increasing demand and production," Mr. Chalupka says. The most efficient companies will often excel, and their share prices and dividends will respond correspondingly well.
As the appeal of fixed-interest investments has faded, many investors have looked instead to equities paying dividends.
But the increased popularity of these stocks has compressed dividend yields, making many once-decent paying options less attractive. Moreover, equities come with volatility risk, something investors in Canada's energy sector learned the hard way when oil prices fell, laying waste to oil company share prices and more importantly their dividend payouts.
Some investors have thus moved some of their money into alternative assets.
Institutional investors have used these traditionally as hedges against inflation and higher interest rates, says Vikram Rajagopalan, vice-president of retail sales and national accounts at Trez Capital in Toronto. "But more elderly clients are now starting to embrace these investments in their retirement portfolios."
The reason is that alternative assets, such as private financing for infrastructure projects and private mortgage real-estate funds, are generally not highly correlated to interest rates and markets. They also often pay higher yields than publicly traded securities, such as stocks and bonds.
"We're able to spit out 6 or 7 per cent but, granted, with certain risks," Mr. Rajagopalan says about Trez Capital, a firm that specializes in short-term mortgages with higher rates than traditional mortgages and offers funds that yield between 5 and 9 per cent.
Unlike GICs, the principal is not guaranteed. Moreover, these products are not subject to the same level of disclosure as publicly traded investments such as stocks and mutual funds. So investors have to do more homework than they would with other securities. They also must realize most alternative assets are not liquid like stocks and bonds.
"If you might want your money back in a hurry, this isn't the asset class for you," Mr. Rajagopalan says.
For example, Trez Capital investors must wait 30 days before they can access their cash. And during a "black swan" event, such as the 2008 financial crisis, "where there was a challenge in valuing any of the mortgages, Trez made a determination to not accept any new capital in or return capital to unit-holders for a period of 180 days."
Alternative assets should make up only about 10 to 15 per cent of a diversified portfolio of cash, stocks and bonds, Mr. Rajagopalan says. So investors still must use largely traditional means to strike a balance between the need for income and managing the risks posed by inflation and interest rate fluctuations.
"The reality is that the only way to keep pace with inflation," Ms. Kett says, "is to invest in assets that, on an after-tax basis, generate a rate of return equal to or greater than inflation."
Corporate bonds can outpace inflation but are slightly more risky than government bonds. But their yields have compressed too as more investment dollars have poured into this asset class. Ms. Kett notes hard assets such as real estate also rise with inflation, so some may consider their principal residence as an option, using its equity to generate income. As well, owners of investment properties can charge higher rents as prices rise.
Near-retirees and retired investors should worry less about inflation and fret more over continuing low interest rates, says Rob Tetrault, a portfolio manager and vice-president with National Bank Financial in Winnipeg.
"If interest rates remain low, fixed-income investors will either have to be willing to accept lower returns and adjust their lifestyles, which is often impossible or impractical, or be willing to adjust their portfolios by adding equity," he says.
Some may be quite comfortable with larger portions of their retirement savings exposed to stock market volatility. But for others it's too much to bear, he says. For them, one option might be equity-linked GICs, which allow investors to participate in stock market gains while often providing a guaranteed minimum return (though some only protect the principal).
Yet these, too, are not without their warts. When markets are rising, investors in equity-linked GICs generally receive only a portion of that upside. And during a bear market, these investments likely will underperform bonds and traditional GICs.
No matter the strategy, though, income-seeking investors need to accept the new reality, Ms. Kett says. "You can't beat inflation without assuming more risk."