Conventional bonds are looking less rewarding as the prospects for a rising yield curve dim. That’s driving investors to what appear to be more rewarding parts of the fixed-income market. Thus, investors are having either to shop down-market and take on risk or quit bonds and move into substitutes to generate capital gains.
For example, you don’t get much of a bonus for going long on Government of Canada bonds, which paid 2.38% for 30 years, or just 25 basis points (bps) more than the 2.13% for two years, as of mid-September. Similarly, the yields on senior corporate debt also are compressed.
As a result, investors searching for yield are heading for sub-investment grade and non-rated corporate debt as the high-yield market average spread over investment-grade debt was 356 bps at the beginning of September, according to Barry Allan, president and chief investment officer of Toronto-based Marret Asset Management Inc. That’s lower than the average long-term premium over investment-grade debt of 425 bps.
“Spreads are below average for the late cycle bond market,” Allan explains. “Default rates are low, but there are warning signs, such as the flattening yield curve, record equities prices and multiples, little breadth in the equity market driven by a few tech names, and manias such as bitcoin and marijuana stocks.”
Thus, the push is on to find fixed-income alternatives. The candidates are preferred shares, real estate investment trusts (REITs) and mortgage investment corporations (MICs). All march to different drummers than those that drive stocks and conventional bonds.
The preferred share market can thrive when interest rates rise because the most popular form of preferred shares, rate reset issues, can add payout and thus show rising prices when specified rates, such as the five-year Canada bond, go up. We are in a flat yield curve environment, so “the spreads on preferred shares are low,” says James Hymas, president of Hymas Investment Management Inc. in Toronto.
The S&P/TSX preferred share index began September at 712, up from 698 at the same time in 2017. The modest 2% gain reflects the essentially short nature of the five-year resetters, Hymas explains. For the second quarter, Canadian preferred shares turned in a less than inspiring performance, up by 0.85% for the period. That beat conventional bonds, which were up by just 0.5% for the period. But conventional bond indices, which are heavily weighted toward government issues, offer liquidity that preferred shares, which are largely a retail product, cannot match.
Meanwhile, REITs don’t provide fixed-income, per se, but what amounts to participating income in rents paid by tenants in apartment buildings, shopping centres and office buildings. REITS’ fortunes depend on the underlying assets. As an asset class, REITs are doing well. The largest, RioCan REIT, was up by 6% for the 12-month period ended Aug. 31 while the broader S&P/TSX capped REIT index was up by 11% for the same period. REITs are equity participants at the end of the line of secured lenders. Units trade like stocks and many of the largest are liquid. But they behave like leveraged fixed-income hybrids.
Investors willing to give up the liquidity that bonds and preferred shares offer can reach for yield in less liquid MICs. Each MIC is a pool of capital that invests in private mortgages. Compared with investment-grade bonds, they are risky; compared with conventional preferred shares and preferred share mutual funds, they are illiquid. Most MICs invest in high-yield, uninsured residential mortgages, although rules allow them to hold up to a quarter of their assets in actual real estate.
Romspen Mortgage Investment Fund, one of the larger MICs, posted a 7.8% return for the first two quarters of 2018, slightly less than its 7.9% return in all of 2017. This MIC’s minimum investment is $150,000 and is restricted to accredited investors. Redemptions are monthly unless demand for cash exceeds 3% of fund assets, according to the fund’s regulatory information. Romspen Mortgage Investment Fund has $2.4 billion in assets, making it one of the larger MICs in Canada.
Although Romspen Mortgage Investment Fund is a good news story, MICs, which often hold speculative construction loans, are clearly in the high-risk, fixed-income category, says Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C.
This is the second in a four-part series on fixed-income investing.