Is your portfolio as conservative as you think is it? It used to be that the fixed-income portion of your portfolio was designed to achieve three goals:
- Protect and preserve your capital;
- Generate income; and
- Diversify your portfolio with assets inversely correlated to stocks. In other words, when stocks go down, bonds go up, when stocks go up, bonds go down.
But what’s happening now in the world of bonds?
Let’s just say that their best years are now behind them. Standard bond portfolios now offer only a negligible current yield and are fraught with downside risk. As for meeting those three traditional goals, they are as useless as “a knife without a blade, for which the handle is missing,” as the saying goes.
Remember that bond prices move in the opposite direction of interest rates, as I explained in my last video. When rates go up, bond prices go down and vice versa. So, as interest rates have dropped from 18% to almost 0% over the last forty years, they’ve been carried by a strong tailwind, turning them into something like a Swiss Army knife for portfolios to achieve several goals.
Now that interest rates are at an all-time low and will more than likely rise again if only to help offset inflation, investing in bonds is akin to having a sword of Damocles hanging over your portfolio. Rising rates mean falling bond prices. Therefore, one can no longer claim that they meet the three goals of capital preservation, income, or inverse correlation (fluctuation in the opposite direction).
Bond Fluctuation Explained
We’ve already explained that bond prices go down when rates go up, to reflect the loss of opportunity of investing at the new, higher rate. Moreover, it is easy to calculate the fluctuation in bond prices when you know the fluctuation of interest rates. It’s simply a question of knowing the concept of duration, which can be roughly summarized as the average term of a bond’s cash flows. To calculate the drop in the price of a bond held in the event that rates start to rise, you simply multiply the duration, expressed in number of years, by the inverse of the change in rates… But here’s an example – there’s nothing better to help you understand.
- If a bond has a duration of 2 years and rates rise by 1%? The bond’s price will fall by 2%.
- If a bond has a duration 2 years and rates rise by 2%? Its price will fall by 4%.
- If a bond has a duration of 10 years and rates rise by 2%? Its price will fall by 20%.
You can easily apply the math to the bond component of your portfolio.
In Canada, the benchmark used to structure a bond fund is the FTSE Canada Universe Bond Index. Since the funds of large financial institutions are almost all based on this benchmark, we can use the features of this index to draw a composite picture of the fixed-income component of investors in a basket of bonds, standard mutual funds or exchange-traded funds.
The duration of the FTSE Canada Universe Bond Index is approximately 7 years, so you can see that a 1% increase in rates would result in a potential loss of 7%. A 2% increase would cause a 14% drop and so on, so you can say goodbye to any capital protection objective you may have for funds built based upon this benchmark. If that’s your goal, you’d be better off with GICs (guaranteed investment certificates) or money market securities. However, it’s hard to generate income with this type of investment.
Since the FTSE Canada Universe Bond Index has a yield to maturity of approximately 1.75%, it’s easy to understand why the gross income of most bond mutual funds of large institutions is negligible. Plus, investors need to deduct management and administration fees as well as taxes to determine their average return at maturity. You’d be hard-pressed to claim you could generate income with them! If income generation is your goal, one option would be to turn to preferred shares, corporate debentures or a fixed income portfolio without constraints.
Now if we add the concept of inverse correlation – bonds rising when stocks fall – to the mix, well, we’ll just have to forget about it! It’s easy to see bond prices falling in tandem with a decline in stocks. For instance, just think of a strong hike in inflation.
Should we eliminate fixed-income securities from our portfolios?
Although you won’t find fixed-income securities that achieve all three objectives at the same time as you could before, the fixed-income component of your portfolio is still very important. To draw a parallel, just because the roads are full of potholes doesn’t mean our need to drive on them has disappeared!
It’s easier to generate good performance figures when rates are falling. That said, investors can still do well even when rates stop falling. The trick, however, is to think outside the box.
How to build a fixed-income portfolio when rates are low
These days, the first rule to follow is to shorten your maturities. Avoid buying very long-dated bonds, since the longer their duration, the more they will be impacted by a potential rise in rates.
When buying government bonds, you can try to choose maturities that are in line with where the yield curve is steepest. Let’s explain. We know that interest rates are generally higher when the maturity is longer. When you plot a graph that shows the relationship between interest rates and maturities, you will notice a curve that normally looks like a sliding slope.
You can usually find a place on the graph where the slope is steeper. This area of the curve shows where you can get the greatest increase in return by increasing the maturity or duration of the investment. This strategy is called “rolling down the curve.” It allows investors to use the passage of time to lessen the impact of a potential rate increase on the value of a bond.
For instance, let’s say the yield curve shows 3% for a 3-year maturity and 4% for a 4-year maturity as of today, and an investor buys a 4-year bond. Then, let’s imagine that rates rise by 1% (across the curve) in the first year of this investment, so the investor’s bond will have a new maturity of 3 years. The impact of the 1% rate increase will be offset by the time that has elapsed -1%.
Corporate debentures that do not have a credit rating have a big advantage to consider. When a company issues a new bond to borrow money, it can hire a third party to evaluate the credit risk of the bond, a very expensive proposition. Sometimes, it’s cheaper for borrowers to pay higher interest by saving on the fees charged by S&P, DBRS or other credit-rating firms. Debentures without a credit rating are sometimes backed by a warrant or a conversion right, which allows investors to benefit from a possible increase in the issuer’s share price.
We also suggest that investors look at preferred shares. They are attractive in several ways. First, preferred stock rates are currently higher than bond rates. Second, preferred shares can have floating rate clauses that reset. This has the effect of driving prices up when rates rise, unlike bonds. Last but not least, the current income from preferred shares is paid out in dividends rather than interest. This is an important advantage for taxable accounts.
Unlike buying a range of bond maturities, these strategies are more complex. We therefore strongly recommend seeking professional advice. Extreme diversification is necessary to limit the credit risk of corporate securities.