For conservative investors, a truly difficult balance

By Michael Nairne | Mid-February 2016

The current yield to maturity (YTM) of a default-free government bond is a reasonable estimate of its future expected return. Studies have found that the correlation between the beginning YTM and the subsequent realized return on 10-year US treasuries is in the 0.9 range. As interest rates change, the gain or loss on reinvestment income is offset by roughly the loss or gain on the principal value.

Unfortunately, Canadian federal government bonds hit record lows in mid-January. According to the Bank of Canada (BoC), the 10-year Government of Canada bond had a YTM of 1.14% as of Jan. 15. More recently, the YTM of the FTSE TMX Canada mid-term all government bond index has been in the 1.7% range. Hence, the anticipated return from "safe" Canadian federal and provincial bonds is minimal.

Investors with an appetite for credit risk will find that yields from investment-grade Canadian corporate bonds - even with elevated spreads vs Canadas - are only in the 2.7% range. If the BoC is successful at hitting its 2% inflation objective, the real return from government bonds could be negative for a prolonged period, while corporates might eke out only slightly positive real returns.

No relief from low interest rates is in sight. The BoC has joined the European Central Bank and Bank of Japan in monetary easing and the BoC recently announced its willingness to implement a negative interest rate policy if needed.

In a 2014 study, the International Monetary Fund concluded that there are no compelling reasons that real interest rates will return to the levels of the early 2000s. A shortage of safe bonds, lower real economic growth, reduced rates of investment and more accommodative monetary policy all contribute to reduced real interest rates.

For conservative clients - particularly retirees - low interest rates are an immense challenge. In response, some financial advisors have suggested higher income securities instead: high-yield bonds, preferred shares, high dividend-yield stocks and real estate investment trusts.

Unfortunately, none of these is a substitute for investment-grade bonds: all of those securities involve significantly higher risk. Not only are these alternatives more volatile; during recessions, their correlations to equities skyrocket and their drawdowns are greatly in excess of those of investment-grade bonds.

During the peak of the crisis that ran from Sept. 1, 2008 to Jan. 31, 2009, Canadian high-yield bonds and preferred shares experienced drawdowns of minus 12.3% and minus 19.9%, respectively. Canadian investment-grade corporate and government bonds had returns of minus 2.3% and positive 3.1% in the same period.

Other advisors suggest holding cash as a substitute for bonds, awaiting eventual interest rate hikes. The risk in this strategy is that either a recession or, more dangerous, the onset of greater deflationary pressures, might result in further interest rate drops. To illustrate, the 10- year Japanese government bond just hit an all-time low YTM of 0.10%.

Today's low interest rate environment necessitates some difficult discussions with conservative clients. They face the hard choice of either materially reduced retirement income "tomorrow" or assuming more risk "today." The trade-off has not been this difficult since the inflationary 1970s.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own securities mentioned in this article.

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