It has been a tough summer and autumn for stocks. Bonds, on the other hand, have performed comparatively well, and may be particularly appropriate for clients closer to retirement who don’t want to risk large losses that they don’t have decades to recover from.
For the six months ended Sept. 30, 2011, the S&P/TSX composite index was down by 17.7%. But Canadian bonds that make up the DEX composite index were up by an average of 5.4%, and U.S. corporate bonds in the Salomon corporate bond index were up by 12.6% in Canadian-dollar terms. Bonds have thrived as investors around the world have fled stocks.
Bonds have also typically been viewed as well suited to RRSPs, as there are few other ways to shelter interest income from taxes. Stocks held in RRSPs, on the other hand, don’t benefit from the dividend tax credit or the deductibility of capital losses. Bonds are also the ballast of the investment classes, offering the type of low risk that many experts say should be an element of retirement-savings plans.
The question now is: are bonds still good bets for your clients?
The answer depends on what your clients want: return or security. Camilla Sutton, chief currency strategist for Bank of Nova Scotia in Toronto, notes that investors who burrowed into U.S. and Canadian government bonds in spite of yields below the inflation rate in each country have largely given up on the idea of real yield high enough to make a decent living. Says Sutton: “They want nominal safety for their money, the certainty that they will get their money back; and liquidity, the ability to get their money out at a moment’s notice.”
Bond mutual funds, bond-based exchange-traded funds and government bonds can provide that security.
The problem of bond selection in today’s environment of dismal yields is that, with rates for 10-year bellwether U.S. treasuries and Government of Canada bonds both yielding about 2.2%-2.3%, there is little interest income to cover any drop in the price of the bonds. And, within their 10-year lifespan, interest rates are likely to rise.
Finally, if you take the nominal yield and subtract the 1%-1.5% management expense ratio typical for bond funds, there is little left for the investor who can only console him- or herself with the advantages of the RRSP’s deferred-tax shelter.
“For many investors in today’s contracting capital markets, bonds seem to be the only place to be,” says Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C. “The problem is how to do it so that trading costs don’t eat what little return there is. Managed funds with low fees are an alternative to actual bonds. Bond ETFs with fees as low as a fifth of 1% leave more on the table for the investor. Both mutual funds and ETFs give the investor diversification, low trading costs within the funds and easy access to pricing.”
That pricing shows where the value lies in investment-grade bonds. Corporate bonds still pay well. For example, a Sun Life Financial 5.59% issue due Jan. 30, 2018, has recently been priced to pay 4.44% to maturity. That’s 253 basis points over a Government of Canada 4.25% issue due June 1, 2018, that has recently been priced to pay 1.91% to maturity. In spite of a recent drop in Sun Life’s quarterly earnings, the bond is investment-grade and the company has cash flow that is 210% greater than what is needed to cover its bonds.
For any investor, the problem that remains is not just beating inflation today but broader portfolio strategy. While stock markets are rocky, returns on the safest bonds are at historical lows, often not even keeping up with inflation or management fees, and some higher-risk bonds may even result in losses.
Despite these conditions, however, there are still good reasons to have bonds, explains Chris Kresic, co-head of fixed-income and a partner in the Toronto office of Jarislowsky Fraser Ltd.: “When you have bonds in a portfolio, you have some balance for stock losses. You can sleep better and you don’t have the psychological pressure to sell before stocks have recovered.”
So, as a comfort blanket, bonds inside RRSPs can help your clients realize their long-term portfolio goals. Bonds can reduce the fear induced by falling stock prices, give a better structural balance to a portfolio and produce a predictable income.
What’s more, Kresic says, recent spikes in bond prices induced by investors’ widespread flight from stocks are not necessarily the peak of the bond market: “Bond prices and yields tend to move in long waves. I am not convinced that we are at the peak of the bond market yet. It could run for a few more years.”
That would mean that long bonds, in particular, could produce good returns — especially if economic recovery falters and inflation declines.
Indeed, in late October, the Bank of Canada had predicted that inflation numbers are on a downward path. Low rates, therefore, are sustainable for what could be another two years.
Low inflation rates raise the bottom-line issue of what is a good return. Says Kresic: “I am comfortable taking a 5% return on a bond portfolio, even if I could get 7% with a lot more risk on stocks.”
And that is really the point. As Huston Loke, president of DBRS Ltd. in Toronto, says: “Flat is the new up.”
In other words, in a world that is experiencing a crisis of confidence, solid bonds that hold their value, pay at least enough to cover inflation (and maybe a couple of percentage points more) and that can be sold at an instant for cash — perhaps to return to stocks when there is a market recovery — make a lot of sense.
For your clients, corporate bonds, which, when held in a well-diversified portfolio, have risks not much greater than any Canada or provincial bond. But diversification is costly if it means buying small lots of bond issues. So, portfolios of bonds using managed funds or ETFs make sense for most retail investors.
In addition, managed funds can boost returns by the use of trading strategies that an individual client would find hard to match. Says Michael McHugh, vice president of fixed-income and a portfolio manager who runs fixed-income investments for Toronto-based Dynamic Mutual Funds Ltd.: “Trading strategies will be the only way to add value in this market.”
ETFs, although usually strategy-neutral, are the middle course — able to profit from the continuing crisis of confidence in capital markets for very low costs. Retail clients seldom have access to the strategies used by professional bond traders, so low-cost funds are typically best for retail clients.
“We are putting our clients at least partly in fixed-income,” says Adrian Mastracci, president of portfolio-management firm KCM Wealth Management Inc. in Vancouver. “We look not just at return but also at how much risk clients can handle.
“Bonds temper that risk,” he adds, “and investments such as bond mutual funds with reasonable fees and bond ETFs with low fees are good ways to reduce the total risk in a portfolio.” IE