Options for income in a low interest rate world

The key is to draw income from a diversified asset base that provides a blend of different types of income as well as capital gains. Traditional income sources include government bonds and guaranteed investment certificates (GICs). There are also higher-yielding corporate bonds, dividend-paying common and preferred stocks, real estate investment trusts (REITs) and emerging markets bonds.

“Emerging markets bonds are doing well compared to traditional asset classes,” says Sergei Strigo, portfolio manager at Amundi Asset Management of London and sub-advisor to Excel Emerging Markets High Income Fund, sponsored by Mississauga-based Excel Funds Management Inc. “They provide substantially higher returns, with slightly more volatility than U.S. treasuries, but much less volatility than stocks.”

Although interest rates are low, there is still a place in balanced portfolios for traditional fixed-income securities, such as government bonds and term deposits. Bonds remain a useful portfolio stabilizer as well as an income source, but they do fluctuate in value. Long-term bonds tend to be particularly susceptible to swings in value, creating the potential for capital gains or losses if they’re sold prior to maturity.

At this point in the economic cycle, with interest rates unlikely to drop significantly, short-term bonds offer more flexibility to investors to adapt to any interest rate hikes, as investors are not locked in for an extended period.

With bonds, the yield usually increases with the level of risk. Higher income can be found by climbing up the risk scale from Government of Canada bonds to provincials, corporates and foreign bonds.

“With global bonds you can take advantage of different interest rate cycles around the world, and can often find higher coupon rates and yields in the bonds of foreign countries,” says Elizabeth Lunney, senior vice president at the private client division of Franklin Templeton Investments Corp. in Toronto.

Dividend-paying common stocks are also attractive. Higher yielding common shares typically boast yields of 2% to 3% before the dividend tax credit — and dividends can increase over time, significantly increasing the yield. Also, investors often enjoy a rise in the market price of the stock as dividends rise.

“We look not only for yield, but for companies that have enough cash flow to pay dividends as well as reinvest in the growth of the business,” says Scott Lysakowski, vice president and head of Canadian equities at RBC Global Asset Management Inc. of Toronto and lead manager of PH&N Canadian Income Fund.

“If they can grow the business and expand the asset base, it will lead to higher dividends in the future. We are investing in companies that are exposed to the recovery in North American growth.”

Preferred shares tend to pay higher dividends than regular common stock. A good quality preferred can be found with yields around 5%, and that’s before the benefits of the dividend tax credit.

REITs also continue to offer an attractive income stream. Real estate mutual funds investing in the bricks and mortar of actual real estate properties are another income alternative.

In an environment of low returns, it is important to determine where securities are best held – whether in a registered plan like a RRIF or RRSP, or in a non-registered plan. Income that is tax-advantaged, such as dividends or return of capital, is best utilized outside of a registered plan, while regular interest income is best sheltered from tax within a registered plan.

Rather than trying to manage individual securities, some investors may be better off holding income-oriented mutual funds or exchange-traded funds (ETFs) that have a mixed bag of income-paying securities and pay a regular distribution.

This is the first article in a three-part series on the quest for income. Next: the pros and cons of preferred shares.