Investors
must be selective
In the
weeks following the 9-11 terrorist attacks, a few of my articles have stressed
rational thinking and a need to always keep in mind the basics of portfolio
design. Part of sticking to the basics is the inclusion of some exposure to
fixed income, in one form or another, to provide some stability. However, with
today’s ultra-low interest rates, investors are wondering where to get that
exposure.
Fixed
income investments include things like (ranked from least to most aggressive
within this category) cash (i.e. treasury bills, GICs, savings), government
bonds, corporate bonds, and preferred shares. Unless otherwise noted, a
reference to fixed income in this article refers to the total of all of those
types of securities.
Bonds are a
necessity and play two important roles in investment portfolios. Bonds provide
an important stability element to portfolios by generating a consistent income.
The income cushions the volatility of other investments. Also, bonds have the
important job of diversifying away some of the risks of stock investing. As for
how much you should have, that really depends on your specific rate of return
requirements, your comfort level with risk, your time horizon, your tax
bracket, and other factors affecting your asset mix. A good rule of thumb is to
make sure to always have at least 20 per cent in fixed income.
If you buy
into the fact that you should have some fixed income exposure in your
portfolio, the outlook for interest rates may have an impact on the type of
fixed income securities you’ll choose. The Bank of Canada lowered its overnight
lending rate this week by three-quarters of a percentage point, down to 2.75 per
cent. That is the lowest figure in forty years.
Given the
current state of the economy, it is unlikely that interest rates will move much
in any direction. Until there are clear signs that economic growth is really
starting to gather some momentum, interest rates are unlikely to see any big
moves. For a refresher on how governments use interest rates, revisit this
recent article (http://www2.myto.com/money/tidd_fs.cfm?source_id=&id=1004600)
on inflation protection.
There are
different theories on what influences interest rates. They range from today’s
yields having built-in expectations, to simple supply and demand factors, to
expectations of future risk. Not one of these theories fully explains interest
rate movements, though I would give more credence to the latter two. This isn’t
the place to get into a long and drawn-out discussion of interest rate
projections, so I’ll cut to the chase and say that short-term rates should rise
substantially once the economic recovery arrives.
Over the
past year or two, interest rates have really dropped on the short end of the
spectrum, while longer rates haven’t moved all that much. Hence, if rate hikes
are eventually expected at the short end of the spectrum, holding a larger than
usual cash position (which will benefit from rising rates) is a good strategy.
This is best accomplished using high interest savings accounts offered by such
institutions as ING Direct and PC Financial.
Buying
bonds directly has natural appeal. There are usually no commissions to buy or
sell; they offer guaranteed rates of return if held to maturity; and you don’t
have to pay any fees along the way. However, there are disadvantages to buying
bonds directly.
While no
commissions are explicitly charged, a larger investment will result in a more
favourable yield. In other words, the commission is built into the yield quoted
by the broker. Hence, comparison-shopping is a must.
Reinvestment
risk refers to the fact that interest payments from bonds may be reinvested at
a lower rate. That’s not a big concern in this environment but in fact it would
be a benefit if rates rise. What should concern the bond investor is the
ability to reinvest interest payments. Unless the interest payments are
sufficiently large, it may not be possible to efficiently reinvest them
directly into other bonds.
Recall that
the bond yield figures quoted in papers and online assume the reinvestment of
interest payments back into the same bond. That’s just not possible with
conventional bonds. That’s where stripped bonds (aka “strips”) come in handy.
Strips are basically bought at one price, and mature at a higher price – with
no interest payments. They effectively allow bond investors to enjoy a compound
return since there is no interest to reinvest. The only problem: with rates likely to rise, it’s more
beneficial to generate interest that can be reinvested – at presumably higher
rates along the way.
If you buy
bonds directly, don’t spread things out too thin. Buying several maturities
requires a bare minimum of $100,000 to $250,000 before it can be done
efficiently.
Recall that
rising bond yields (which is what I would expect) results in falling bond
prices. That only matters if you want to sell before a bond’s maturity. If
you’re holding until the maturity date, interim movements are irrelevant. In
this environment, fees charged on bond funds should be a primary consideration
in your choice of funds. For instance, consider the fact that government bonds
carry yields ranging from a little over 3 per cent to just under 5.5 per cent.
If you consider that the average Canadian bond fund charges 1.9 per cent
annually, you’ve just given away one- to two- thirds of gross bond yields in
management fees and operating expenses.
Beutel
Goodman Income (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=125&FundKey=11614),
McLean Budden Fixed Income (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=283&FundKey=12502),
Perigee Active Bond (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=253&FundKey=13227),
and PH&N Bond (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=299&FundKey=13203),
are my favourites in this category. All have management expense ratios (MERs)
between 0.58 and 0.75 per cent per year and require minimum investments ranging
from $2,500 (Perigee) to $25,000 (PH&N). In bond mutual funds, the saying
“you get what you pay for” couldn’t be further from the truth. Instead, it
should be “you get to keep what you don’t pay out in fees”.
If you’ve
decided you want exposure to corporate bonds and/or preferred shares, these are
best entered into with the help of a full service stockbroker or via a mutual
fund. Good funds emphasizing corporate bonds include PH&N High Yield (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=299&FundKey=14631),
and Trimark Advantage Bond (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=106&FundKey=13962).
My favourite preferred-share-heavy dividend funds are Dynamic Dividend (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=161&FundKey=11210),
GGOF Guardian Monthly Dividend Ltd. Classic (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=277&FundKey=11659),
and Spectrum Dividend (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=200&FundKey=13589).
As much as
possible, investments generating interest income should be sheltered in
registered plans, like RRSPs and RRIFs. If your RRSP is small or non-existent,
you may want to concentrate your fixed income holding in Canadian preferred
shares. Dividends paid by Canadian companies are tax at a reduced rate. If your
taxable income is under $30,000 dividends are taxed at an extraordinarily low 5
per cent marginal tax rate. Be careful though, too much dividend income could
affect things like the non-refundable age credit for seniors and the refundable
GST credit. The total net tax advantage of dividend income must be carefully
examined.
Like all
investment decisions, first decide on your asset mix strategy, then look at
which investments best meet your risk and return expectations and fit your
other constraints. Then look at how to maximize after tax returns.
Despite
today’s super low interest rates, fixed income still deserve a place in your
portfolio. A lower than normal bond component and higher than usual cash
position may be a good way to maintain some stability while still profiting
when rates eventually rise.
Dan Hallett, B.Comm.,
CFP, CFA is Senior Investment Analyst with Sterling Mutuals Inc. He can be
reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.