Exploring fixed-income alternatives

The bond market offers other fixed-income alternatives, including real-return bonds in Canada and U.S. Treasury inflation-protected securities, neither of which looks good in a low-inflation environment. Ditto for bond ladders, which could have a year or two of low and dropping yields.

Next in the search for yield comes riskier income assets from non-investment-grade debt, which are decidedly less secure than senior bonds.

Let’s begin with junk debt. The Merrill Lynch master II high yield index yielded 10.0% for the 12 months ended Nov. 20 on a yield-to-worst basis (that is, assuming debt will be called). That basis is a threshold for judging the returns of other issues, especially those on the next rung down in income dependability: preferred shares.

Preferred shares are equity, but have a defined return, so they are fixed-income in the minds of many investors. Nevertheless, preferreds are poor alternatives to conventional fixed-income, particularly the perpetual rate resetters that dominate the market these days. That’s because when interest rates rise, the resetters may have to boost their payouts or, if rates jump before the reset date (usually every five years), the issuers will just buy them back and pay the holders of the shares $25, the customary price.

Another source of yield is split shares, which reorganize common shares into two types of shares: capital shares, which get all the price appreciation; and income shares, which have no price participation, but get all the income from shares in both classes. Some share classes yield as much as 6.25% at time of writing. They are marketable, but all are levered on interest rates. These securities tend to lose value as interest rates rise as some investors defect and move their money back into bonds. As well, a rise in interest rates implies lower profits and less distributable income for heavily leveraged companies.

As for public/private partnership (P/P) bonds, they are doing well and have good ratings. These securities offer some of the solidity of government bonds mixed with the higher yield and risk of corporates. There are not many P/Ps, but such benchmark issues as the Greater Toronto Airport Authority, which has a DBRS rating of A (high), offers a yield of 117.5 basis points (bps) over long Canadas, while the Highway 407 bond, rated A (low), trades at 138 bps over long Canadas. These P/P yields are in line with other corporates of similar rating and term, notes Chris Kresic, head of fixed-income and asset allocation with Jarislowsky Fraser Ltd. in Toronto.

Mortgage investment corporations (MICs) are in the homeowner market. MICs gather money from participating investors, each of whom becomes a shareholder, then lend at rates far above those of chartered banks. These days, the low end of rates is 6%-8% and they often go over 10%. MICs seem like a terrific ride, but beware the downside because their mortgages are not insured. That said, MICs have a fairly good record because they specialize in owner-occupied homes. For example, in the third quarter of 2018, MICs had a 1.93% default rate compared with a default rate of 0.24% for chartered banks and 0.17% for credit unions and caisses populaires.

Liquidity is an issue for private MICs, as they often require months of advance notice for redemption. Publicly traded MICs’ shares can be sold and cash realized on conventional two-day settlement.

Syndicated mortgages (SMs) have known and identified security — unlike MICs, which do not allow the investor to select the property on which money is lent. The investor’s name goes on the title of an SM. The upside is that SMs allow smaller investors to join other investors in specific properties. The downside is that SMs provide no guarantees of return, may be in line to be paid after a bank or other senior secured lender, lack liquidity and require potential investors to do a great deal of due diligence. Investors must ensure that the borrowers can pay what they owe, that the property provides good security and that the property is valued fairly. Many SMs work out well, but a few cases (such as that of Fortress Real Developments of Richmond Hill, Ont.) show what can go wrong.

Fortress, a player in the SM market, raised $920 million from 14,000 investors in Canada who wanted low-risk, steady income. A December 2018 story by Janet McFarland published in the Globe and Mail reveals how easy it is for SM promoters to get inexperienced investors to join. Fortress pitched a development in Barrie, Ont., called Collier Centre. The project offered an 8% annual return with a two-year return of capital.

Few investors knew that Fortress’ senior managers had a record of failed companies and were in partnership with developers who had been fined by provincial securities regulators. Worse, Collier was emerging from bankruptcy and earlier investors had not been paid almost $17 million they were owed. An estimated 10,000 investors holding a combined $700 million in loans still haven’t been told what they will get back.

Therefore, caution is advised.