With equity markets volatile, fixed income investments continue to be an important component of risk management in investor portfolios.
Whether your clients are cautious retirees living off their assets or young people looking to balance their portfolios with a stable income component, advisors face the challenge of finding investments offering a healthy income and minimizing risks, at a time when interest rates remain at rock bottom.
“Yields on government bonds are lower than inflation, which means a loss of purchasing power over time,” says Scott Colbourne, co-chief investment officer of Toronto-based Sprott Asset Management LP and lead portfolio manager of Sprott Diversified Yield Fund. “Fixed-income investing is no longer an easy lay up. The key is asset allocation within fixed-income, so that the risks associated with different parts of the portfolio can offset each other. It’s important to be flexible in a challenging environment.”
A diversified fixed-income portfolio provides different types of income from a variety of sources, as well as the potential for capital gains.
Traditional income sources include Canadian government bonds and guaranteed investment certificates, but the interest payments on these products are miniscule. There are also higher yielding corporate bonds, dividend-paying common stocks, convertible stocks, preferred shares, real estate investment trusts (REITs), global bonds and emerging markets bonds.
In addition, there are portfolio products available through mutual funds and exchange-traded funds that offer diversified packages of different types of income securities, at varying levels of risk.
“Many investors looking for a better return on their fixed-income investments are going global and adding corporate and high yield bonds,” says Daniel Solomon, chief investment officer at NEI Investments, a division of Northwest and Ethical Investments LP of Toronto.
Investors are also looking for ways to manage the risk of rising interest rates. Given the sluggish global economy, rates may not see any significant increases for some time, and if rates do begin to turn up, it will likely be at a slow and cautious pace.
Even so, any increase in rates poses risks for traditional fixed-income products. Bonds and other products issued at today’s rates will look relatively less attractive if market rates rise, and their market values will adjust downward accordingly.
Short-term bonds and floating rate products offer more flexibility to adapt to interest rate hikes, as investors are not locked in for an extended period. However, if the global economic slowdown worsens and the threat of recession and deflation becomes stronger, higher yielding long-term securities will be relatively attractive.
Certain regions pose a greater risk than others.
“Within fixed-income, there are areas we favour relative to others,” says Michael Greenberg, vice president of Franklin Templeton Solutions, a division of Toronto-based Franklin Templeton Investments Corp. Given the potential for U.S. policymakers to raise rates, for instance, he says that U.S. government bonds face greater risks. He prefers economies that are tied to commodity prices, such as Canada and Australia.
“As commodities come under pressure that hurts their economies, and this leads central banks to keep things on easier footing with low rates,” Greenberg says.
Dividend-paying stocks offer the benefit of being able to increase their dividends as the company grows, plus they possess additional potential for capital gain if the stock price increases. Yields on higher yielding common shares are in the 3% range on average, before the dividend tax credit, which is considerably healthier than the current yield on a 10-year government of Canada bond of 1.3%.
Preferred shares tend to pay higher dividends than regular common stocks, and REITs also offer a healthy income stream. Real estate limited partnerships, and funds or pools investing in actual real estate properties, present other options for income-seekers.
In addition, Greenberg says it’s important not to overlook capital appreciation as a source of return, particularly if dividend-paying stocks hit a fallow period. “Series T” mutual funds or a program to regularly sell off units in funds can convert various kinds of return to income, with any portion in capital gains or dividends being more tax efficient than traditional interest.
“Income doesn’t necessarily have to come from traditional income sources,” Greenberg says. “You can be more flexible, and it’s not necessary to be constrained by focusing on yield alone.”
This is the first article in a three-part series on fixed income investing.
Up next: Getting fixed income exposure with ETFs.