There is a dilemma facing financial advisors across the country. Ultra-low interest rates have made the task of finding secure sources of income for clients a challenging, if not an apparently impossible task.
Government bonds, the traditional safe haven for investors, are having trouble keeping up with inflation and, worse yet, could lose value if the U.S. Federal Reserve Board ever makes good on its threat to raise interest rates. That’s a situation that has some financial advisors seeking innovative solutions and others cautioning clients to reduce retirement expectations or to work a bit longer.
Some of those solutions may have hidden pitfalls. “I have spoken with many advisors, and many of them are using dividend-paying stocks,” says John De Goey, portfolio manager with Montreal-based Industrial Alliance Securities Inc. in Toronto. Despite the advantages (lower tax rate on dividends, yields higher than traditional bonds), loading up portfolios with dividend-paying stocks is not a strategy that De Goey agrees with.
“I fundamentally believe,” he says, “at the end of the day, dividend-paying stocks are still stocks. They are not bonds; they are not to be used for income.”
Alternatives to bonds
De Goey, who has been expecting rate hikes since 2011 – “I’m not wrong; I’m just early” he jokes – has used principal- protected notes (PPNs) to fill out a portion of clients’ portfolios that typically would be filled using bonds in a more conventional environment. “What [PPNs] offer is some of, but not all of price appreciation, [which is], ironically, the exact opposite of a dividend because you don’t get the dividend [with] a basket of stocks,” he says.
If the market drops, investors do get their money back with PPNs, as the product’s name implies.
De Goey has been using PPNs for more than five years, a period during which the stock market generally has risen. This period also was a time when bond investors have been happy for the most part, as rate hikes have not materialized. Both bonds and stocks will drop eventually, but, De Goey says, “when the stock market is off, my clients are guaranteed to get their money back.”
Dustin Van Der Hout, portfolio manager with Richardson GMP Inc. in Toronto, also is avoiding government bonds when constructing client portfolios: “Retirees who are in the traditional asset-management space who are being put into traditional bond funds have no idea of the amount of risk that an elongated, low-interest bond has. A lot of old people are going to get very hurt.”
Van Der Hout’s first step is to suggest lower retirement spending, although many clients say they “still need the income, want the income, need to generate it,” he says.
For those income-hungry clients, he has some sophisticated strategies.
“What I have been doing is finding closed-end bond funds that trade at a significant discount to what they are worth: let’s call it 5% or 6%. So, I get the underlying bond portfolio, which might be able to do 3% or 4%, but I get a 5% discount to the [bond fund’s net asset value],” he says. “So, all of a sudden, people’s fixed-income is doing 10% for them.”
Andrew Beer, manager of strategic investment planning at Winnipeg-based Investors Group Inc., recommends considering high-yield bonds that pay superior yields vs government or investment-grade bonds – but with one caveat: “You have to be very careful. There is volatility associated with high-yield bonds. They do have characteristics similar to equities, [in that] there is the risk of default and a lot of [high-yield bonds’] success depends on the health of the economy.”
Guarantees
Beer also likes segregated funds and guaranteed income funds. “The nice thing about them is that they give the client the opportunity to combine an investment with guaranteed payments for life,” he says. “You can be looking at anywhere from 3% to 5% [in annual payments], depending on the person’s age.”
In the guaranteed investments space, Beer also suggests that clients consider T-series funds that provide a set payout. This is a tax-efficient strategy because much of the income is classified as return of capital. (See story above.)
Diane McCurdy, president of Vancouver-based McCurdy Financial Planning Inc., is one advisor who is reluctant to take on risk to juice up fixed-income returns. She sees too much short-term uncertainty (political turmoil in the U.S., Brexit and China’s ongoing economic slowdown) to adopt a strategy of chasing returns. And she is pulling clients out of real estate mutual funds; although they have been strong performers for the past 15 years, their returns are flattening out now.
She also avoids bonds, for the most part, and is putting clients into short-term guaranteed investment certificates, which typically pay a little more than government bonds and do not carry the downside risk of bonds.
“We are always trying to ‘knock it out of the park’ for our clients. But what we really are there to do is protect them,” she says. “When you are talking about getting income, when they are at that point, you really can’t lose capital.”
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