Intolerably low interest rates are causing a major rethink of diversification at the individual investor level.
Here’s an example from a reader: “I am a 60-something do-it-yourself investor. I have three years of living expenses in a high interest savings account. In lieu of bonds, I have 20 per cent of my portfolio in perpetual preferred shares (Royal Bank of Canada, Great-West Life, George Weston and Toronto-Dominion Bank). Does this make sense?”
Subbing pref shares for bonds is logical, yes. Perpetual preferreds are kind of like bonds that pay dividends instead of interest and have no set maturity date. Yields on perpetuals might be in the 5 per cent range, compared with roughly 0.4 per cent for a five-year Government of Canada bond and maybe 1.4 per cent for a competitive one-year guaranteed investment certificate.
For generating investment income, these preferred shares clean the bond market’s clock. Especially in taxable accounts, where the dividend tax credit reduces the tax hit on the cash payouts from preferred shares. But does it truly make sense to substitute prefs for bonds? Not if you subscribe to the idea that the main point of bonds is not to generate income and returns, but rather to act as a portfolio life preserver when the stock market turns ugly.
In tough times, investors want a sure thing. A bond issued by a government or blue-chip corporation qualifies. Preferred shares? Not so much. Holders of pref shares rank ahead of common shareholders when dividends are threatened by a company’s financial problems. But preferred shareholders are behind bondholders.
What investors really want amid financial market turmoil are government bonds. The FTSE Canada All Government Bond Index posted a total return of 3 per cent for the three months to March 31, while the much broader FTSE Canada Universe Bond Index made 1.5 per cent. Brace yourself for the performance of the S&P/TSX Preferred Share Index for that hellacious three-month period – a drop of 22.8 per cent.
The preferred share index mainly holds rate reset preferreds, which are unattractive in the kind of interest rate decline we saw early in the year. Perpetuals are somewhat less touchy, but they’re not to be counted on in a stock market crash.
This distinction is meaningless to investors who are all about income and fine with portfolios that bounce around in price. It sounds like the reader who asked about pref shares might be this kind of person.
Anyone who gets scared in market crashes needs bonds. Pref shares, sure. But bonds as well.
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