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Investor Education

Remember the true meaning of fixed income Add to ...

Two years of white-knuckle stock markets have relegated bonds to the backwaters of the average retail investment portfolio. Let's face it - it's hard to get excited about bond returns when the Bank of Canada benchmark interest rate has plopped to a measly one-quarter of 1 per cent.

But experts urge investors not to lose sight of the strategic importance of fixed income as a portfolio stabilizer.

"You should have some sort of fixed income at all times," says Stan Wong, vice-president and associate portfolio manager at Macquarie Private Wealth.

He admits it's difficult to squeeze returns from fixed income without taking too much risk or committing to a ridiculously long term.

"You've gotta go out 30 years to get four per cent on a Government of Canada bond ... 30 years."

To strike a balance he puts his client's money in high-quality, shorter-term corporate bonds such as the big Canadian banks, which average a yield of 4 to 5 per cent. He says George Weston Ltd. bonds pay out a similar yield with comparable risk.

The best payouts come from high-yield corporate bonds - known in the market as junk bonds. While the term "junk" may seem like a risky venture, Mr. Wong says they should have a place in even a conservative investment portfolio. To dilute the risk he recommends a basket of high-yield bonds in the form of an exchange-traded fund.

"You would want to be exposed to the sector, not one individual issuer," he says.

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IShares has two high-yield ETFs on the market - one in U.S. dollars under the symbol HYG, another hedged to the Canadian dollar under the symbol XHY.

Claymore also offers a new Canadian-traded high-yield bond ETF with the symbol CHB.

The two Canadian-traded funds have a short track record but the iShares High Yield Corporate Bond ETF returned 15 per cent during the past year.

Yields are generally highest and default risk is lowest for junk bonds in a recovering economy.

Assuming the recovery continues, Mr. Wong expects his model portfolio to generate a total annual yield of 4 per cent to 6 per cent.

The purpose of fixed income is no matter what the yields are you protect your principal and you get your money back. Hank Cunningham, Odlum Brown

However, for clients who are concerned about inflation he recommends real-return bonds, which pay a yield of 1.5 per cent above inflation.

To further dilute risk he "ladders" fixed-income portfolios by staggering maturities over a period of seven to 10 years. Laddering provides frequent opportunities to take advantage of the best interest rates available at the time of maturity.

The right proportion of fixed income to equities in a portfolio depends on the individual investor. One rule of thumb says the percentage of fixed income should equal the investor's age.

Mr. Wong says bond funds and the fixed-income portion of balanced funds should be included in the fixed-income mix. "I would still consider it fixed income because it does pay out an income and it has the components of an income fund."

However, Hank Cunningham, a fixed-income strategist at Odlum Brown, disagrees. He says fixed-income securities that are exposed to market swings are not really fixed income.

"The purpose of fixed income is no matter what the yields are you protect your principal and you get your money back.

"It's the sleep-at-night side of your portfolio."

He says right now investors should be looking for gains only on the equity side of their portfolios where dividends are often higher than bond yields - and the two sides should never cross.

"People are stretching themselves for extra income and yield.

"This is how they got themselves into trouble in the income-trust fiasco because they didn't realize that income trusts were actually equities, and now they're buying junk. That's another pigs-get-greedy scenario."

That's not to say he thinks investors should load up on government bonds. He says good quality corporates such as Brookfield Properties, H&R REIT, banks, utilities and pipelines can yield as much as 3 per cent more than government bonds.

He also agrees ETFs are a good way to get exposure to high-yield bonds.

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Mr. Cunningham says a laddering strategy of up to seven years should produce returns of 3 to 5 per cent - assuming inflation stays below 2 per cent.

In the meantime, he says, investors should kick back and enjoy record low inflation and rock-bottom mortgage rates.

"Inflation is no threat to the bond market this year or next."

Dale Jackson is a producer at Business News Network


Market footprint: As of 2009, the size of the worldwide bond market is an estimated $82.2-trillion.

Who holds them? Ninety per cent of bonds are held by institutional investors such as financial services companies and pension funds.

The ratings: Bonds rated AAA and BBB are generally considered investment grade. Bonds rated BB or lower are considered high yield.

The yield: The listed rate of return on a bond is considered the "nominal rate." The rate of return minus inflation is the "real rate."

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