Lately a few pundits have been talking about increasing their exposure to fixed income investments, and I just don't get it. In fact, I think that's a big mistake.
When I say I don't get it, I don't mean that I understand it. I know why they are saying that now is the time to own this type of asset. It basically comes down to trying to protect against future market volatility by getting some money out of the equity markets.
Well-known mutual fund personality Gordon Pape has been quoted as saying "Moving some assets from an equity fund to a money market or bond fund during periods when stock markets are going through a rough time is only prudent." But just let's think this through for a moment.
What "stock markets going through a rough time" invariably means is that they have come down in price, and to an uncomfortable degree. So what Pape is really saying here is "sell stocks after they get cheap," the perverse opposite of what a rational investor would do.
Right or wrong, the concept of protection against market volatility has some appeal. But fixed income? Really?
If the argument that a person should reduce their equity exposure in favour of fixed income has some appeal to you, then I've got three points to make. First, know what you are getting into and why. Second, make sure you know the risks. And third, know that other products may be more attractive.
So what is fixed income? Well, basically what the term fixed income refers to is simply lending money to people, and then they pay you back with interest. Bonds are by far the biggest example of fixed income investments, with billions of dollars worth in circulation.
Certainly bonds can serve a valuable role as one component of a financial plan. And for some people they will be just the ticket. Right now, though, too many people are buying bonds for the wrong reasons. If you are going to buy bonds, at least buy them for the right reasons.
Let me start with why so many people are buying bonds right now. It's because they are disappointed with the volatility from equity investments, and bonds have some respectable short-term performance numbers.
What you need to know, though, is that bonds have benefitted from a 32-year tailwind, and that party is coming to an end. In fact, it's inevitable that bonds will be flying into a headwind at some point because the value of bonds fluctuates inversely to changes in interest rates. In other words, bonds do well when interest rates are going down, but not so much when interest rates are going up, and sooner or later interest rates are going up.
Much of the past performance of bonds is not simply from the interest that is paid on the bonds, but because of windfall profits stemming from a declining interest rate environment. Back in the 1980s, when interest rates were sky high, bonds did great. They did great because inflation and interest rates plummeted. In the 1990s bonds continued to do well, because interest rates continued to come down. Last year bonds did just fine because the Central Banks kept interest rates low to stimulate the economy.
But that was then, and this is now. Let's look at what you are getting with fixed income investments in today's markets.
You aren't getting paid very much to own bonds right now The ten-year Government of Canada bond is yielding a historical low, paying less than two per cent. And that's two per cent before fees, mind you. The annual fees on a typical Canadian bond fund might cost you 1.2 percent annually. In other words, take the two per cent gross yield on the bonds, subtract the 1.2 per cent in fees, and you are left with a scant 0.8 per cent for the investor.
But even worse is the looming prospect of rising interest rates.
With current interest rates only slightly above sea level it is ridiculous to expect that the conditions that generated decent returns for bond investments in the past will be able to continue.
After 32 years of declining interest rates, at some point interest rates are going up, and that's bad for bonds. In other words, people running from the volatility of the equity markets could be running right into a bad patch for the fixed income markets.
If we get a one per cent increase in interest rates, the value of a typical bond fund in Canada is going to decline by about five per cent. If your bond fund is yielding a measly 0.8 percent per year, how many years does it take you to recover from a five per cent drop in the value of your shares?
Another thing to keep in mind is why a person should buy bonds in the first place. Bonds are designed for income. But what if your investment objective is not income, but growth? Or liquidity? I flip out when some asset allocation program says that because I am a certain age I need such and such a percentage of my RRSP in bonds. Forget that. I don't want income; I want my RRSP to grow.
Still, bonds can be fine if you hold them to maturity. Bonds can give you a predictable, reliable income. If you hold them to maturity then interest rate fluctuations are not an issue. You'll get your coupon rate, and won't have to worry about capital losses. So they do have a role. Just make sure the role that they can play is consistent with what you are looking for.
Certainly bonds can complement an equity portfolio to smooth out performance. I remember doing up a financial plan for a retiree, who had a portfolio worth about $100,000. That's not a ton of money when you need to stretch it out over many years, so we needed her money to be working efficiently.
Her risk profile meant that we needed diversification amongst asset categories to reduce portfolio volatility. We had a nice blend of foreign and domestic investments, including global bonds.
Immediately after we set up the portfolio global bonds went in the tank.
She hated them. She was doing well with the overall asset mix, but she was fixated on the global bonds. It seems like every time she got her quarterly statement I needed to re-emphasize the value of diversification to her. On many occasions she was tempted to jettison the global bonds and put the money in one of the other asset classes that at the time were doing better.
The moral of the story is that the global bonds saved her bacon when equities went in the tank.
Bonds can serve a valuable role in diversifying a portfolio.
That being said, while bonds can add an element of diversification, is this the time to flee equities? Or would that be trying to shut the barn door after the horse has already escaped? In hindsight, minimizing equity exposure prior to the 2008 meltdown would be good fortune, but that's water under the bridge now.
Meanwhile, bonds aren't the only way to diversify a portfolio.
Personally I like to use Guaranteed Minimum Withdrawal Benefit products as a substitute for fixed income, with the objective of acting as a stabilizing influence on a growth-oriented portfolio. With these products the amount that your future income is based on will go up by at least five per cent per year between now and when you start taking the money out, and when you do start taking money out your income is guaranteed for life as long as you follow the plan.
That five per cent minimum stacks up pretty nicely against current bond yields, and if the markets
perform you get a piece of the
upside too.
At the end of the day, if you are going to buy bonds then do it for the right reasons. Don't buy them because of past performance, and don't buy them if they don't fit in with your objectives.
Brad Brain CFP, R.F.P. CLU, CH.F.C., FCSI is a Senior Financial Advisor with Manulife Securities Incorporated, in Fort St John, BC. The opinions expressed are those of Brad Brain, and may not necessarily reflect those of Manulife Securities Incorporated. Manulife Securities Incorporated is a Member of the Canadian Investor Protection Fund. Brad Brain can be reached at [email protected] www.bradbrainfinancial.com.
