Your clients’ crum–bled portfolios can be rescued. The trick is to do that without increasing the risk of further losses, as nobody needs to add downside potential in this economic environment.

But rather than making a play on stocks recovering or declining further, putting money into investment-grade bonds that are priced well below their face value increases the probability of recovery and can raise income as well.

The choices are far from black and white, however. Most investors already have some fixed-income assets in bonds, bond funds or balanced funds. So, the question is one of rebalancing the ratio of equities for future growth with bonds for short-term recovery.

Last year, the S&P/TSX total return index dropped by 33% and the S&P 500 total return index lost 37% in U.S. dollars. Today, your clients can buy an index proxy or specific stocks on the chance that the market has discounted all the bad news to come. Conversely, they can short the market, on the theory that it has not fallen enough. But these strategies are closer to gambling than investing.

Adding bonds and reducing stocks is, of course, not the only way to position a portfolio for recovery. But buying losing stocks and waiting for the recovery amounts to lowering the adjusted cost base of a portfolio, which is an accounting concept rather than a genuine investment strategy.

In gambling theory, buying losing stocks gets close to the idea of geometric betting; that is, if you lose $1, you bet $2, if you lose that, then you bet $4. If you can keep up the betting until you get a win, the return is everything that has been bet — plus $1. At best, this is an inefficient way to invest and makes no economic sense at all. So, risk management is a far better way to set up a recovery plan.

“You need to look at the return you need in your portfolio and then reverse-engineer what you expect from stocks and bonds,” says Andrew McCreath, a senior portfolio manager with Sentry Select Investments Inc. in Toronto.

“If, for example, a portfolio is down by 35% from its June 2008 level and if the goal is just to get back to that summer’s starting point, then you can take some losses on the losers and use the cash to buy investment-grade bonds that pay, say, 8% a year,” McCreath suggests. “You then wait about four years, add a little compounding and your clients have their money back. You will have done it with bonds that are much less risky than stocks,” he adds. “Three years from now, there could be a good recovery in Canada, although much of it would be delayed until prices of commodities, which underlie a lot of the Toronto Stock Exchange’s value, rise.”

This recovery model suggests increasing the fixed-income component to between a third and half of a portfolio. This would make up most of the recent losses, while the stocks’ recovery would do the rest, McCreath says: “The difference in this approach, which is adding to the bond weighting [rather than] just waiting for stocks to recover, is that the stock recovery [method] is more speculative than reallocating money to bonds that are very likely to rise in value to their redemption prices and to pay interest at a substantial multiple of stock dividend yields.”

Moreover, adding to the bond weighting gets a portfolio out of the boom/bust equities cycle and into the far more certain proposition that investment-grade bonds, which have been heavily discounted, will rise in price to maturity and pay interest handsomely until then.

“Of all the theories for recovery, shifting to fallen corporate bonds from fallen equities makes the most sense,” says Edward Jong, senior vice president with Toronto-based MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund. “With bonds, you reduce your risk and you can raise your running yield. For the patient client, it is a surer way to recover from losses than doubling down and buying more stocks — or even staying with stocks that have fallen.”

A move to bonds from stocks is opportune because although stocks appear to be relatively cheap, credit-sensitive bonds are at long-term lows, says Dan Bastasic, vice president of investments with Toronto-based Mackenzie Financial Corp.: “Bonds can’t be said to be able to outperform stocks in the long run, but since bonds are at historical lows, you can add to potential return without adding more risk.”

@page_break@Examples of relatively high returns from investment-grade bonds are not hard to find. An A-rated Toronto-Dominion Bank Tier 1 perpetual issue, callable on June 30, 2019, has recently been priced to yield 8.2% to its call date. As well, a Sears Canada Inc. issue due May 10, 2010, with a rating of BB, which is slightly below investment-grade, has recently been priced to yield 7.45% to maturity. A Sherritt International Corp. issue, rated BBB and due Nov. 26, 2012, has recently been priced to yield 7.88% to maturity. The market says these bonds are very good bets to pay and they are short- to mid-term issues as well.

Buying bonds is not an escape from risk, but it is a shift to lower-risk debt with a fixed return from high-risk stocks, says Caroline Nalbantoglu, a registered financial planner with PWL Advisors Inc. in Montreal: “If an investor has made the error of being 100% or even over 80% invested in stocks, then the portfolio should be adjusted to a suitably higher bond weighting. That is the amount to shift into high-grade, credit-sensitive debt. Raising the bond allocation now and waiting for the recovery is the less bumpy way to get back to the point at which a portfolio was before the meltdown.”

For the patient client who wants to recover lost portfolio value, the logic of shifting to bonds with time certainty from stocks with timing issues is clear: the risks are less and the quality of assets is higher. The only drawback is that, over the long run, bonds will continue to return less than stocks. As to what that’s worth in headaches and uncertainty, only your client can say. IE