With interest rates at rock bottom levels — and rate hikes expected in the months ahead — investment managers and economists have low expectations for fixed income returns this year. But by making adjustments to the fixed income component of a portfolio, financial advisors can help clients maximize income and minimize the impact of rising rates.

The Bank of Canada’s key rate remains at a historic low of 0.25%, which has left government bond yields at depressed levels, and bond investors with little income.

“The landscape for return was rather low this year,” says Adrian Mastracci, portfolio manager and president of Vancouver-based KCM Wealth Management Inc.

Many economists expect the Bank of Canada to begin raising interest rates in the third quarter of this year. Avery Shenfeld, managing director and chief economist at CIBC World Markets Inc., expects the central bank to raise its key rate by three-quarters of a percentage point in the third quarter.

Such a hike could deal a blow to the price of bonds, and particularly long-term ones. “Those bonds will suffer a capital loss,” says Mastracci.

He is urging clients to reduce their holdings of bonds with maturities exceeding five years, and replace them with shorter-term bonds that are less sensitive to changes in interest rates.

“You probably would want to stick within three to five years at best,” Mastracci says. But he warns that the returns on these investments will be modest: “Your yields are not going to be fantastic.”

For clients seeking higher yields, advisors should look beyond government bonds to corporate bonds, preferred shares, and other income-oriented investments that typically offer higher payouts.

“We favour corporate bonds over government and provincial bonds because they have improving balance sheets and higher yields,” says Frank Wiginton, a certified financial planner with TriDelta Financial Partners Inc. “In addition, there are significantly less issues of corporate bonds so there is an inherently higher demand.”

Corporate bonds currently offer fairly attractive returns of roughly 5%, according to Terry Carr, vice president and managing director of fixed income at MFC Global Investment Management (Canada).

Carr is lead manager of the Manulife Yield Opportunities Fund, a new fixed-income-oriented fund designed to provide higher rates of return than bonds and GICs. It invests in corporate bonds, as well as high yield bonds, preferred shares, dividend-paying common stocks and other income-oriented securities, and is targeting a 6% annual distribution, payable monthly.

“It’s a product that’s designed to respond to the low interest rate environment that we find ourselves in,” explains Carr.

He says the fund will largely be shielded from the impacts of interest rate hikes, since assets such as high yield bonds and common equities are not very sensitive to interest rates.

“The impact on the fund is expected to be muted over the coming year,” says Carr.

Several similar income-oriented funds have also emerged in recent months, as investor demand for higher yield grows. For example, Claymore Investments, Inc. recently launched the Claymore Advantaged High Yield Bond ETF, and Phillips, Hager & North Investment Management Ltd. introduced the PH&N Monthly Income Fund, which targets an annual distribution of 5%.

But advisors must keep in mind that with the higher yield comes higher risk, which may not be suitable for all fixed income investors. Warren Baldwin, regional vice president with T.E. Financial Consultants Ltd. in Toronto, says it’s important to keep a client’s risk tolerance in mind.

“If they need to have a conservative mix, there’s plenty of rationale behind why that’s in place,” Baldwin says. Even when interest rates are extremely low, he avoids making any substantial adjustments to clients’ fixed income holdings, and focuses on maintaining their long-term asset mix.

But Carr says many investors are likely willing to stomach a bit more risk for higher returns. He considers the Manulife Yield Opportunities Fund a “modest to moderate risk instrument.”

“People are looking for a way to edge into the market in a careful, considered way,” he says. “We believe that they’re willing to take on a little bit of market risk, as long as it’s not excessive, to try to generate a higher rate of return than something closer to 1%.”

IE