Some of the most creative – and suspect – investment thinking of the past few years comes from people trying to deke around low bond and GIC yields.
The more investors substitute other assets for bonds and guaranteed investment certificates, the more risk they add to their portfolios. Let's look at some examples:
Individual dividend-paying common stocks
Blue-chip dividend payers are unlikely to cut or suspend their quarterly cash payouts to investors, although the examples of Manulife Financial, Telus and TransCanada over the past 15 years show it does happen. The bigger risk is a jolting price decline in a dividend stock. Bonds can fall in price, but they won't shock you with the kind of plunge that dividend stocks are capable of. Remember – bank stocks lost roughly half their value in the 2008-09 market crash. You own bonds as a buffer against just this sort of event.
You're automatically more diversified if you own pretty much any dividend mutual fund or exchange-traded funds instead of a few individual stocks. But some dividend funds are heavily skewed to the financial sector. Example: The Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY) had almost 57 per cent of its assets in financials as of the end of September. If you have exposure to bank stocks elsewhere in your portfolio, a dividend ETF could put you well offside.
Floating rate products
A growing number of funds offer investors exposure to floating rate bonds, short-term corporate notes and preferred shares. The sales pitch: Floating rate investments offer protection against the rising rates we've been expecting for five years, but not actually seen. If rates stay flat or decline – the pattern of 2014 for sure – then you're getting little in the way of returns. Moreover, some floating rate funds hold bonds issued by companies with low-quality financials. This type of debt would get hammered in a stock market correction.
Prefs are often categorized as fixed income, along with bonds and GICs. But they offer a level of volatility that is roughly half way between bonds and stocks. Do not expect your preferred shares to bail out a portfolio being crushed in a stock market plunge.