Ask about the golden rule of asset allocation and Adrian Mastracci answers with a slow, hopeless chuckle.
With bond yields at rock bottom, the 42-year-old veteran financial adviser and chief financial planner at KCM Wealth Management says telling investors the percentage of fixed income in their portfolios should be near their age is a tough sell.
"I think most people find it too boring" he says. "A stock is much more exciting."
It's an even harder sell with the U.S. Federal Reserve holding off on its plan to withdraw stimulus and locking its benchmark interest rate near zero. Yields on some of the safer bonds have actually slipped below inflation. (Even the U.S. government shutdown didn't make bonds more appealing – investors showed little immediate need for a safe place to stow their cash. Whether they will change their minds if the shutdown is prolonged remains to be seen.)
As more baby boomers enter or near retirement he says the need for safe, steady income is more vital than ever. Yet most new clients he sees don't take fixed income seriously. "Usually it's just a few dribs and drabs – a little cash here and there, maybe a bond or two, a GIC. It's not something they think about as part of the asset mix."
A basic asset mix has three components: equity (stocks), fixed income (bonds) and cash. The exact composition depends on the individual investor's tolerance for risk and the time until retirement, also known as time horizon.
Equity has the potential to grow in value but carries the most risk. Fixed income is intended to provide steady income and stabilize risk from the equity side of the portfolio. "You try to have the boring part, the guaranteed part, of a portfolio that will hold you through no matter what you encounter. It's something you can always fall back on," he says.
The plan worked in the stock market meltdown of 2008. Fixed-income investments went relatively unscathed, while equities lost roughly half of their value in a few months. Mr. Mastracci says instead of learning a lesson, many investors are trying to make up for those losses by overloading on equities. "People have very short memories," he says.
His advice is a 40- to 60-per-cent weighting in fixed income including cash, savings accounts, bonds, GICs, T-bills and money market funds. He says bond and GIC maturities should be no more than three years and laddered annually to take advantage of rising yields as often as possible.
To help supplement lacklustre returns he suggests solid dividend-paying stocks. "A good quality security, paying dividends – sometimes increasing dividends – you can make a pretty good case that that's really fixed income with a little upside to it."
Hank Cunningham, fixed income strategist at Odlum Brown, takes a more literal view of fixed income. "Rule No. 1 in our business is to keep what you start with."
He says securities such as dividend stocks, bond funds and even bonds that are traded before maturity don't count as fixed income because they have the potential to decline in value. "Bond funds never mature and the fees are 1.8 per cent on average. They're no place for an individual investor. They are just a waste of money."
He expects inflation of 1.5 per cent to 2 per cent over the short term but cautions investors not to get hung up on real returns. "It's very difficult to imagine returns after inflation being positive in the bond market."
On the bright side, he says help is on the way for investors who stay true to fixed income. As the economy strengthens the U.S. Federal Reserve will eventually ease up on its stimulus program, prompting higher interest rates and higher yields.
He says to avoid any government bonds until the benchmark 10-year U.S. bond reaches 4 per cent. It is currently less than 3 per cent.
In the meantime, Mr. Cunningham says the best way to squeeze the most out of a fixed income portfolio is through a laddering strategy reaching out from seven to 10 years.
Like equities, he says the key to boost returns without increasing risk is diversification. He recommends a mix of investment grade corporate bonds, but any single company should not account for more than 10 per cent of the fixed income portfolio.
For exposure to high yield, or junk bonds, he makes an exception to his "no bond fund" rule and suggests an exchange-traded fund that accounts for no more than 5 per cent of the portfolio.
These are unusual times for the bond market because there are larger-than-normal differences in maturities as they get longer. He recommends one laddering strategy – referred to as "rolling down the yield curve" – to take advantage of the large yield gap between maturities. It allows investors to get extra yield by purchasing bonds every year with four- or five-year maturities.
(Mr. Cunningham feels four- and five-year bonds are long enough to get a decent yield and short enough to mature before yields on comparable maturities really start rising.)
As a rule, bond values increase as they near maturity. In this environment, yields on four- and five-year bonds nearing maturity are also higher than bonds with corresponding maturities. In other words, a five-year bond that is one year into its term has a better yield than a four-year bond with the same distance to maturity.
Eventually, the bonds will mature every year giving the investor a steady stream of income and plenty of opportunities to reinvest as new bonds with higher yields are introduced to the market.
When that will happen is just about anybody's guess, but Mr. Cunningham estimates interest rates will begin to rise in two years when central banks such as the Fed start raising their rates.
He says in normal times bonds are supposed to earn two per cent above inflation. "We're seeing the recovery from that anomaly and yields are returning to positive real yields."