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portfolio strategy

You can build retirement income with minimal risk bonds and GICs and avoid the volatility of stocks.Spencer Platt/Getty Images

Soaring interest rates in 2022 have undermined an argument for tolerating the stock market’s endless unpredictability.

Investing in stocks is all about accepting a serious risk of losing money in order to have a chance of beating the returns available from safer assets like bonds and guaranteed investment certificates.

In the low-interest decades of the past, stocks were essential to reach your investing goals. But with 5-per-cent returns available from both bonds and GICs, how much do investors need stocks?

Darryl Brown, investment planner at You & Yours Financial, recently applied this question to the retirement investments held by his 80-year-old parents. The result was a portfolio makeover that puts the biggest chunk of assets in a ladder of corporate bonds, where bonds mature gradually over time.

Mr. Brown started with a calculation of how much income his parents received from the Canada Pension Plan and Old Age Security, and their spending needs. He then calculated that interest paid by bonds, with just a sprinkling of dividends from preferred and common shares, would give his parents the additional income they need to live on.

The lack of stock market exposure suits his parents well, said Mr. Brown, who holds the chartered financial analyst (CFA) designation. “They don’t need to be flipping through the financial pages or listening to the news, and they love it.”

Stocks are the focus of most investment advice because they offer the potential of superior returns – maybe 6 to 7 per cent on a long-term average annual basis after fees. Projecting mastery of stocks is an easy way for investment advisers to demonstrate expertise to clients, and investments that hold stocks typically pay higher fees and commissions than bonds, bond funds and GICs.

Advisers have a couple of talking points to downplay the utility of GICs right now, one of them being the opportunity cost of locking money into a return that could, at least in theory, be bettered elsewhere. Another is that as much as interest rates on GICs have risen this year, they still lag an inflation rate that last clocked in at 6.9 per cent.

Offsetting these objections is the fact that GICs have outperformed stocks handily this year with virtually no risk if you stay within deposit insurance limits. Bonds are a different story – 2022 has shown how vulnerable they are to price declines when interest rates rise.

But falling bond prices mean higher yields – prices and yields move in opposite directions. This explains how Mr. Brown was able to find corporate bonds with yields in the 5- to 6-per-cent range. These bonds could fall further in price if rates continue to rise, but price fluctuations are beside the point. His parents hold bonds for interest income, not to have them rise in value.

Another point against holding bonds and GICs is that the interest they pay is taxed like regular income in non-registered accounts, whereas capital gains and dividends are taxed more favourably.

Mr. Brown said his parents are like many retirees in holding their retirement investments in registered accounts. Withdrawals from a registered retirement income fund are treated as regular income, regardless of the types of investments in the account. Withdrawals from tax-free savings accounts are, as the name says, tax-free.

The bonds selected by Mr. Brown for his parents make up 65 per cent of their portfolio. They’re mainly investment-grade corporate bonds of various maturities staggered over the years ahead. The rest of the portfolio is made up of preferred shares and dividend-paying common shares.

Dividend stocks are a justifiably popular way to generate retirement income, but they’re more risky than bonds in two ways. One is that the possible decline for a dividend stock in a bear market far exceeds the decline in bond prices this year. Also, companies in financial trouble might slash their common and preferred share dividends, while still making bond interest payments.

Mr. Brown said the pre-tax yield on the entire portfolio he built for his parents is about 5.75 per cent. Bonds have risen in price since he put the portfolio together, so he estimates a yield close to 5.5 per cent if he were to go through the same exercise right now.

Actual bonds are used here instead of bond funds because they have a firm maturity date where the capital invested is repaid by the bond issuer. Bond funds never mature – they keep rising and falling in price according to interest rate trends.

Bonds offer more flexibility than GICs in that you can choose maturity dates in the months, years and decades to come. GICs are typically available for terms of one to five years, although terms of up to 10 years are available from a few issuers. One benefit for GICs is that you can have the option of receiving interest on a monthly, quarterly, semi-annual or annual basis.

Mr. Brown said the total amount of cash produced by his parents’ portfolio in combination with CPP and OAS is enough to fully fund their needs without dipping into their savings. He believes more investment advisers don’t use bonds and GICs to generate retirement income because they don’t want to do the necessary cash flow planning, or aren’t equipped to do it.

Also, some advisers prefer to focus on generating total returns for clients – stock or bond price increases plus dividends and bond interest – as opposed to creating income that meets a client’s needs for cash flow.

It all comes down to whether the need for cash can be satisfied with bond or GIC interest, Mr. Brown said. “If the income meets an individual’s needs over the course of their life, then they don’t necessarily have to be subjected to the volatility of the stock market.”