The Research Investment Committee at BofA Securities (formerly Merrill Lynch) advised clients that U.S. government debt was a poor form of diversification in their most recent report released on Aug. 11. Treasury yields are simply too low relative to inflation, and this problem also extends to Canadians faced with meagre Government of Canada bond yields.
Government debt has been the main source of portfolio diversification for investors for decades, providing downside protection and lower overall portfolio volatility levels. So, if investors are going to reduce their allocations to government bonds, what should they invest in instead? All of the answers come with issues.
As alternatives to risk-free government debt, the committee published a chart showing risk-adjusted yields for most of the major income-generating asset classes (posted to social media here). The top five were U.S. high-yield corporate bonds, emerging market bonds, collateralized loan obligations (CLOs), U.S. municipal bonds and broader U.S. corporate debt (all credit ratings).
U.S. high-yield debt provides a yield of about 5.0 per cent more than Treasuries. This sounds attractive at first, but it’s also the case that pandemic-related U.S. corporate bankruptcies are climbing sharply, increasing investment risk in the sector.
Brooks Brothers, Chesapeake Energy Corp., Diamond Offshore Drilling Inc., JC Penney Company Inc. and Neiman Marcus Group Inc. are only a few of the prominent names that filed for chapter 11 protection. Corporate Canada hasn’t been spared as shoe sales chain Aldo Group and Foodora have declared bankruptcy, while companies like Calfrac Well Services Ltd. have been forced to restructure debt.
I was all set to write a column about emerging market bond ETFs as a way for Canadians to add yield – there are ETFs with payouts from 4-6 per cent available domestically. But then I remembered that the S&P/TSX Composite is highly correlated with emerging market bond indexes, which means that the sector offers little to nothing in terms of portfolio diversification and risk reduction.
There is no free lunch where income and dividends are concerned in the current market. Investors looking for higher yield beyond the government bond rate are going to have to accept that they are accepting a significant uptick in portfolio risk, and work to understand what market conditions might result in permanent loss of capital.
-- Scott Barlow, Globe and Mail market strategist
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The Rundown
For investors sidelined with cash, market surge presents painful dilemma
When it feels like the world is ending, the allure of cash can be difficult to resist. While it earns next to nothing, cash is safe and liquid, and most importantly, it won’t go to zero. This was the trade-off many investors made earlier this year, when financial markets were convulsing with panic over the global pandemic and the economic lockdown needed to fight the coronavirus, writes Tim Shufelt (for Globe subs)
Dividend stocks are rallying, beating indexes at last
Dividend stocks have been roaring back to life in August, outgunning major indexes and giving some hope to income-loving investors that the upbeat trend is just beginning. David Berman takes a look (for Globe subs)
TFSAs, RRSPs and the tax hikes to come
A bit of personal finance advice to see you through the decades ahead: Fill your TFSA. Fill it to the brim. Tax-free savings accounts are the most universally loved franchise in the Canadian money universe, which suggests a certain redundancy in urging people to exploit them to the max. But as popular as they are, TFSAs are under-used. If governments raise taxes in the years ahead to help pay for their pandemic spending, your best defence is having a topped-up TFSA, according to Rob Carrick (for Globe subs)
Others (for subscribers)
Wednesday’s analyst upgrades and downgrades
Tuesday’s analyst upgrades and downgrades
Rob Carrick: ‘Can you recommend an ETF of companies that will survive and thrive in the pandemic?
Seven U.S. consumer discretionary stocks with sizeable long-term return on capital
Others (for everyone)
Global markets second-guess stimulus policy rollback
Investors revalue Chinese tech giants after U.S. ban
China’s booming metal imports an echo of the last crisis
Facing pandemic squeeze, universities hit bond markets for cheap cash
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Compiled by Globe Investor Staff