We are in a discouraging environment for income-focused investors: Interest rates continue to be very low, while the stock market is vulnerable owing to a long-in-the-tooth economic cycle.
Choosing an appropriate portfolio structure in this scenario may seem challenging, but there are still some good options available.
The textbooks say cautious, income-focused investors should favour high-quality government bonds. But the global markets are reflecting the continuing effects of policy-driven, artificially low interest rates, and, more significantly, extremely low real interest rates (after inflation). This continued financial repression supports the very high debt currently held by so many global governments, but frustrates investors seeking income.
If you lend the Government of Canada money for 10 years, it will pay you an annual return of about 1.5 per cent. Factoring in inflation of 1.5 per cent (never mind taxes), that is a zero return. On top of that, if interest rates go up, the price of the bond will go down. That makes Government of Canada bonds both risky and low-return. The textbooks didn’t contemplate this backdrop in their recommendation.
We will not be rid of the knock-on effects of the 2008 financial crisis until global governments’ balance sheets are back in order and the financial repression lets up. These debts have arisen from a combination of quantitative easing (printing money) and fiscal stimulus, and are typical of a financial crisis. However, we are still living under the shadow of 2008, even after a 10-year bull market. This is unusual.
When it comes to bonds, corporate and mortgage rates are always higher than government rates. In the current environment, the spread is higher than usual. However, in recessions – and at some point, we will have one – some corporate debt and even mortgage operations will be affected by the slowdown and unable to pay the interest due.
Consequently, investors should do some careful analysis before deciding which corporate debts or commercial mortgages are of high-enough quality to withstand decreased economic activity. Mortgages have the added risk premium of being illiquid; unlike stocks, they don’t trade on the marketplace. However, if you don’t need the capital in the short term – and the quality of the mortgage is high – then this is an area of your portfolio to overweight now. You should also favour good-quality corporate bonds over government bonds.
Turning to your stock portfolio, the low-rate environment favours dividend-paying and global stocks. Canada has some terrific companies to invest in – particularly banks and utilities – but what about technology, industrials, consumer stables, autos and drug companies? It’s critical to invest in safe and growing global stocks for sector diversification. We recommend a Canadian-centric approach, with 33 per cent Canadian and 67 per cent global.
Again, careful analysis is needed to be sure that dividends will be safe even during an economic slowdown. Buying only high-dividend stocks is dangerous. Today, you can create a global defensive stock portfolio with a dividend yield of about 3.5 per cent. It will go up less than the broad indexes in a bull market, but will also drop less in a bear market.
The following is not advice for the ages, but the points do apply in the current low-rate environment:
- Hold more cash. This is not a time to be greedy. Keep the equivalent of two times whatever you normally withdraw from your portfolio on an annual basis in a savings account.
- Overweight good-quality and short-maturity (less than five years) corporate bonds, or better yet, commercial first mortgages.
- Overweight defensive, dividend-paying global stocks. These will still decline in price during a bear market, but will not cut their dividends and will recover well when economic activity returns.
By making some careful choices, you can maximize your returns while insulating your portfolio from some of the unpleasant surprises that the current economic cycle may have in store.
Leslie Cliff is a founding partner of Genus Capital, an independent investment management firm that’s celebrating its 30th anniversary this year.