BONDS AND GICS
Why Buy Them?
- High quality bonds and GICs offer one thing that no other securities offer. They mature at par on a known date, which means that even if interest rates rise and the market value of the bond falls, you know you will get your money back in full upon maturity.
- Government bonds offer a high level of liquidity should you ever need to raise funds by selling assets.
Risks and Considerations
- Fixed income securities generally receive the least favourable tax treatment.
- Given current bond yields, fixed income investors would be challenged to derive enough income to meet their spending needs and still maintain purchasing power in the face of inflation.
Portfolio Application
- For investors who require absolute certainty of income and principal, bonds should comprise the majority of their portfolios, if not the entire portfolio, even though it will erode principal over time.
- For investors seeking a balance between income and maintaining future purchasing power, but with a bias towards income, bonds should comprise 60-75% of the portfolio’s strategic allocation. If the bias is towards growth, bonds should comprise 40-60% of the strategic asset allocation.
- When incorporated into a laddered portfolio, bonds can provide a number of characteristics
sought after by income investors, including maximizing yield and flexibility in changing interest rate environments. For more information on laddering, please refer to our recently re-published article entitled “Building the Laddered Portfolio”.
- For investors seeking the comfort of government bonds, there are also opportunities to buy
government agency bonds (Farm Credit, Export Development Corp), which offer incremental yield pick-ups of 13 to 15 basis points in the 5 year area, and 18-21 basis points in the 10 year term, while still offering a government guarantee. There are also a number of provincial bonds that can provide similar value.
- For investors holding fixed income assets in an RSP but will not need to receive income for a few years, Discount Savings Bonds may be a relevant solution. These are essentially strip coupons that turn into bonds at a later date. If purchased to coincide with future income needs, they provide compounding interest now, and income in the future.
CORPORATE BONDS
Corporate bonds can be broken into two categories, investment grade which refers to bonds rated BBB
and higher, and below investment grade, often referred to as High Yield bonds, which refer to bonds
rated BB+ and lower.
Why Buy Them?
- Corporate bonds can offer higher yields than government bonds over the long term.
Risks and Considerations
- Corporate bonds entail a higher risk of default. According to Moody’s Investor Services, 10 year
cumulative default rates average 3.37% for bonds rated A, and 7.82% and 19.35% for bonds rated
BBB and BB respectively (Default & Recovery Rates of Corporate Bond Issuers, published
January 2004)
- Liquidity on corporate bonds can, in adverse situations, be limited. This is especially so for lower
quality bonds rated BBB and lower.
Portfolio Application
- High quality corporate bonds rated A- and higher are generally considered suitable for most
conservative, income oriented investors when diversified over 6-8 issuers.
- Investment grade corporates comprise approximately 25% of the bond market index, which is a
reasonable benchmark for the high quality corporate allocation within most investors’ bond
portfolios.
- As mentioned earlier, the key to investing in High Yield bonds is gaining very broad
diversification which, given the limitations of the Canadian High Yield market, is best done via a
High Yield bond fund. High Yield bond funds should generally not comprise more than 10-15%
of a bond portfolio.
- In some cases, finding attractive high quality corporate bonds may be difficult. In addition, many
bond portfolio managers believe in an approach of investing substantially all of a bond portfolio
in corporates. Naturally, this would require a substantially increased level of diversific ation and
can best be done through a corporate bond fund.
CALLABLE BONDS
This would include some corporate bonds and the majority of structured bond securities, often referred to as Step-Up bonds, or Issuer Extendible bonds. These bonds embed a feature where the issuer of the bond can redeem it at a pre-stated price before maturity, or extend the maturity beyond its original maturity
date.
Why Buy Them?
- Generally, callable bonds will offer a higher coupon and yield than bonds of similar term without
the call or extension feature.
Risks and Considerations
- As an investor, you essentially give the issuer the right to choose the maturity date of the bond,
which they will do to their advantage.
- If interest rates fall, the issuer will redeem the bonds and the investor will be left to reinvest their
money at a lower interest rate.
- If interest rates rise, the bond will exhibit characteristics of a longer-term bond with a term equal
to its longest maturity date. Generally, in a rising interest rate environment, longer-term bonds
would fall in price by more than short-term bonds.
Portfolio Application
- As a strategy, buying callable bonds makes sense if interest rates are expected to move sideways,
so that the investor achieves the higher yield without any adverse affects from having the bonds
called in a falling rate environment or extended in a rising rate environment.
- Callable bonds should not account for more than 10% of a bond portfolio.
PREFERRED SHARES
Preferred shares are equity securities that rank above common stock and just below bonds in a firm’s capital structure. Generally, they pay a regular fixed dividend, and preferred shareholders do not share in
any upside if profits if the company performs well, nor do they have voting rights.
There are many different types of preferreds. In general, most of them are callable by the issuer and offer
a fixed dividend. The two most often sought by investors are retractable preferreds and perpetual
preferreds. In addition to being callable by the issuer, retractable preferreds are also putable or
‘retractable’ by the investor, which means that the holder has some control over the final redemption date
of the security. Perpetual preferreds generally have no end date although they are callable, usually after
their 5th anniversary of their issue date.
Why Buy Them?
- Preferred shares generally offer higher dividend yields than other types of equity, as well as
higher after-tax yields than most corporate bonds of similar issuers.
- Preferred share dividends are taxed more favourably than interest income on bonds.
Risks and Considerations
- Failure to pay dividends on preferreds simply causes the suspension of any common dividend, if
any exists, but does risk forcing the firm into bankruptcy, as would the default on a corporate bond.
- If a dividend is non-cumulative, the investor will have no recourse for recouping missed dividends.
- As preferreds normally have a call feature, the comments made above about callable bonds also
apply.
- Having no end date, the prices on perpetual preferreds will behave in much the same way as those
of long-term corporate bonds in a rising interest rate environment.
- Given strong demand from corporate investors, who often have more favourable tax circumstances than individual investors, retractable preferred yields, after accounting for tax differences between dividends and interest income, are often not much higher than regular corporate bonds.
Portfolio Application
- Though technically equity, we tend to view preferreds more as deeply subordinated corporate bonds. Preferreds could be included as a portion of a corporate bond allocation of a bond portfolio whenever valuations warrant.
- Retractable preferreds are the most conservative type of preferred given that the holder has some certainty as to the end date. In fact, there are securities traded in the bond market, known as capital securities, that have properties similar to those of retractable preferreds.
- Before purchasing perpetual preferreds, first ask yourself if you would be willing to buy 30-year
bonds. If the answer is no, then perpetual preferreds generally will not be a suitable investment.
COMMON EQUITY
Common stocks represent the lowest claim on a firm’s assets in its capital structure and represents an ownership stake in the profits left after all creditors and preferred shareholders have been paid. Common shares provide holders a degree of leverage as they participate in 100% of any increase in profits after bond and preferred holders are paid, but are the first to bear the brunt when a company loses money.
Why Buy Them?
- Common stocks offer a growth element to income investors. They also provide the opportunity to own companies that may profit in a rising interest rate environment.
- As common stock and bond prices do not always move in the same direction, investors stand to reap the benefits of diversification which implies that they should receive a higher return for any level of volatility than if they owned only stocks or bonds.
- Many common stocks pay regular and consistent dividends, which are taxed at a lower rate than interest income received from bonds. A well-managed company may be able to increase their dividends over time.
Risks and Considerations
- Given their leverage to a company’s bottom line, common stock prices are generally expected to
be more volatile than bond and preferred share prices.
- In the event of bankruptcy or reorganization, common shareholders could lose their entire
investment.
- Dividends paid to common shareholders are not guaranteed and may fall. Investors have no
recourse if a company fails to pay a dividend.
Portfolio Application
- For investors who wish to achieve higher returns in order to preserve and grow capital, while still spending a portion of the income or returns generated from a portfolio, a diversified exposure to equities may be suitable. Investors who require absolute certainty and predictability of income would likely avoid stocks in favour of fixed income securities.
- It is advisable to diversify over 20 or more different equity positions, with further diversification
across industries or sectors.
- In general, income investors should favour stocks that have demonstrated an unbroken history of
consistent and growing dividends, and with a relatively low payout ratio (meaning the firm retains sufficient capital to reinvest in future growth). Aside from the obvious desirability of the income stream, investors tend to equate a strong and growing dividend record with sound
company management. As such, these stocks tend to perform better than others in adverse markets.
- Investors who focus too narrowly on the size of the dividend will tend to find themselves heavily concentrated in the financial and utilities sectors, which tend to react negatively to rising interest rates.
- Investors should aim to diversify into stocks in other industries that meet the above criteria in
terms of dividend growth, even if the absolute amount of the dividend is quite modest. Stocks in the materials and industrial sectors tend to perform well in rising interest rate environments.
- High volatility growth stocks which pay no dividends would generally not be considered suitable
for income oriented investors.
INCOME TRUSTS
Income trusts are equity investments with a financial sturcuture that sets them apart from common shares
in a variety of ways. Income trusts are designed to provide investors with a relatively high level of income, as they generally pay out the majority of the operating cash flow generated by the underlying business.
While many investors look at income trusts as income alternatives, it is important to keep in mind that income trusts are equity investments, not fixed income investments. A few of the key attributes of an ideal income trust is a mature, highly profitable business, stable and predictable cash flows, a viable long term business plan , and limited needs for capital reinvestment. However, the market has grown to include an increasingly diverse range of businesses, some of which are probably not well suited for the income trust structure.
Why Buy Them?
- Most investors are attracted to income trusts for the relatively large cash distributions that they
pay. The average cash on cash yield for a business trust is approximately 8%, for the oil and gas
group is approximately 12% and for Real Estate Investment Trusts it is approximately 9%.
- Many investors prefer to have management pay them the cash flow generated by the business
versus taking the risk of management reinvesting the cash flow in other businesses, which may
not work out.
- The income trust structure, with its inherent tax efficiency and its typically more conservative use
of debt has historically shown to be appropriate for certain businesses and industries with
complementary characteristics, and many of those income trusts have performed exceptionally
well.
Risks and Considerations
- Income trusts are high yielding equity investments, and not fixed income investments, therefore
distributions will vary, there is no provision for return of principle, and there is no guarantee that
a unit will be saleable in the future at the price paid today.
- Since income trusts pay out the majority of cash flow, they can be vulnerable to unexpected
operating problems or unforecasted capital expenditure requirements.
- The high payout ratio also implies that income trusts must turn to the capital markets to raise
money to fund growth and to find acquisitions that will sustain its business. This puts the group at
the mercy of the equity markets and their ability to attract investors.
- Much of the appeal of the group has been the high cash yield they provide in a very low interest
rate environment. Since they are income-oriented investments, the underlying unit prices are
particularly sensitive to moves in interest rates. In the event of a marked increase in interest rates,
valuations would be negatively impacted, distributions could come under pressure, and investment performance could suffer.
Portfolio Application
- Income trusts should be treated as part of an investor’s equity portfolio, and investors should use
the same process for investing in an income trust as they would a common stock. In most cases, we would recommend that income trusts not exceed 40% of a stock portfolio.
- Investments should be made based on the fundamental merits of the underlying business, the sustainability of cash flows, and the potential for growth of distributions to unitholders, and much less on cash yield.
- Exposure to income trusts should also be diversified across sectors as well as names, so as to minimize the risk associated with any one income trust. This is the same approach one would take when building an equity portfolio.
ANNUITIES
Annuities are insurance contracts that provide an income stream, consisting of both interest and a return of principal. Normally, the full amount of the investor’s principal will be amortized to zero by the end of
the contract.
There are several types of annuities. Term-certain annuities are the simplest form, having a fixed life,
after which the income payments cease and the principal has been fully amortized. Life annuities provide
an income stream for the remaining life of the annuitant, however depending upon the options chosen, there may be limitations on benefits passed on to a surviving spouse or estate in the event of a premature death (some customization is available but it may reduce the amount of payment).
Insured annuities tie a life annuity with a life insurance contract (policy). With each payment from the
life annuity, a portion of the funds are invested in an insurance policy designed to repay the initial
principal value of the annuity upon the death of the holder. An insured annuity generally provides higher
yields than on conventional bonds and GICs (although lower than on other annuities due to the
reinvestment in the insurance contract), while also providing for the tax-free return of capital upon expiry.
Why Buy Them?
- In some cases, investors may require cash flows that are well in excess of what is available in the
market, or that would otherwise entail taking significant risk in order to be achieved. In these
cases, investors may want to avoid the risk of losing money prematurely in high-risk securities
and focus on an orderly process for liquidating capital over time. Annuities provide such an
opportunity.
- Distributions from annuities comprise both interest and principal portions, of which the latter is
not taxed. Given the timing of the tax payment relative to that of conventional fixed income
securities, the yield, or Internal Rate of Return on a term -certain annuity tends to be very
attractive relative to bonds of similar term, when measured on an after-tax basis.
- Their simplicity provides for a more simple method of amortizing principal than with a more
conventional portfolio of stocks and bonds.
- Life annuities offer the comfort of knowing that you will not outlive your assets.
Risks and Considerations
- Annuities lock investors into a fixed income stream. As a result, holders face the risk that
inflation rises which may cause the purchasing power, or value, of the income received to fall
below what is needed to maintain their lifestyle.
- Annuities are permanent contracts that are not changeable or marketable and therefore cannot be
sold if an investor’s needs or objectives change.
- The certainty attributed to future annuity payments is based on the ability of the insurance company to meet its future obligations, which in turn rests on the insurance company’s ability to generate returns consistent with its actuarial projections.
- There are some limitations and eligibility criteria that could impact the economics of annuity and insurance policy contracts.
Portfolio Application
- We would view annuities as being similar in nature to a non-marketable, customized long term
corporate bond, with the credit risk being that related to the underwriting of the insurance contract
|
SECTION
