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Bond investors caught between a hike and a hard place

Yields generated by the least risky bonds, short-term government issues, are too low to meet many retirees’ income needs while the alternatives may be too risky, especially if rates move higher.

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Bonds have been a winning investment for decades. As interest rates have trended downward since the 1980s, the value of investors' fixed-income holdings have increased.

These days, however, many fixed-income investors aren't feeling quite so victorious.

Yields are at or near historical lows and central bank interest rates in the United States and Canada appear to be trending slowly upward.

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As a result many fixed-income investors – particularly retirees – now find themselves caught between a hike and a hard place.

Yields generated by the least risky bonds, short-term government issues, are too low to meet many retirees' income needs while the alternatives may be too risky, especially if rates move higher.

"Fixed income used to be the portion of the portfolio that we looked to for safety and income," says portfolio manager Robert Broad, vice-president with T.E. Investment Counsel in Toronto. "Now it is really just safety."

Consequently many income-needy investors are moving into riskier assets to generate cash. Some are sticking to fixed income, buying longer duration government treasuries, or corporate bonds.

"The risks are twofold with these strategies," says portfolio manager Hardev Bains, president of Lionridge Capital Management in Winnipeg.

"One is the credit risk of higher-yielding instruments [like corporate bonds,] but the other is the interest rate risk that long duration bonds are exposed to."

As central banks hike interest rates, the value of longer duration bonds are more negatively affected than shorter duration bonds. For example, a 1-per-cent hike would result in a 10-year bond falling in value by about 10 per cent while a one-year bond would fall in value by about 1 per cent.

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Corporate bonds are less affected by hikes than government issues, and they often pay a higher coupon and yield more as a result.

"Currently the yields available on the corporate bond index are about 75 basis points higher than on similar government bonds," Mr. Broad says, adding that is in line with the historical average.

But corporate issues are often more negatively affected by worsening economic conditions.

"They can be more volatile and carry the risk of default," he adds.

What's more is even long duration government bonds and corporate issued bonds don't pay much in exchange for the additional risk as yields on all fixed income are at historical lows. As a result, many investors have sought to generate income from income-producing equities such as dividend stocks and REITs (real estate investment trusts).

In particular, advisors and do-it-yourself investors have focused on preferred shares to generate yield, says investment advisor Darrell Gebhardt, senior vice-president at Bieber Gebhardt Advisory Group in Winnipeg with National Bank Financial Wealth Management.

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"One strategy that we consistently use to find a good mix of yield and safety is preferred shares," he says. "These fall between bonds and stocks in terms of risk classification as they share some characteristics of fixed income and some of stock."

The upside with preferred shares is they often pay a higher and often steadier dividend than common shares.

"The safety lies in the knowledge that the issuer would need to cut the dividend on common stock before it ever touched the preferred [shares,]" he adds.

Their value is affected negatively by rates hikes as investors seek higher yields elsewhere. As well, their market value can decrease as the economic prospects of the issuer – often one of the big banks – and the broader economy dim.

Yet for investors willing to accept the risk, dividends – from common or preferred shares – offer another benefit besides a higher yield when held inside an open taxable account: tax efficiency. Middle income earners typically pay about 50 per cent less tax on dividend income than they would on interest, Mr. Gebhardt says.

"In Manitoba, for investors who have annual income between $45,916 and $68,005, the tax rate on eligible dividends is only 14.12 per cent versus 33.25 per cent for interest income on bonds or GICs."

For retirees relying heavily on registered retirement income fund (RRIF) income, which is taxed as earned income, this is a moot point. Still the higher yield is attractive to investors who can stomach stock market volatility.

Mr. Broad points to the fact that "Canadian dividend ETFs (exchange-traded funds) have yields over 4 per cent, almost double what you can get from the broad bond market."

So while equities may come with greater volatility, "it is hard to imagine not being better off in stocks over the long term," says Mr. Broad, who uses a mix of bonds and equities to generate cash flow for clients.

The problem is not everyone has a long time horizon, especially retirees. A sharp market correction could result in them having less capital and, in turn, a reduced cash flow in the short and long term.

Moreover seeking income from equities can lead to a drift away from stock selection based on good economic and business fundamentals.

Mr. Bains says investors may be tempted to buy companies with rich dividends that are unsustainable because of deteriorating business conditions. In turn the company cuts its dividend and the shares plummet resulting in significant capital losses, he says.

Still equities have their place in many retirees' portfolios providing a mix of long-term capital growth and yield for income. Yet these same investors also have to accept that the fixed-income portion of their portfolio will likely for the foreseeable future provide less income and primarily offer capital protection.

That's why "we have focused only on short duration bonds – five years or less," Mr. Bains says. These securities may not yield much, but they are less affected by rising interest rates.

"For a lot of clients this can be hard to take because they're concerned they're not generating enough income."

To address this worry, he often suggests clients meet their basic cash flow needs with a combination of income from interest and capital rather than stretching for yield in higher-risk assets.

"Most retirees are already dipping into their capital regardless of conditions," he says. "The fact is there are very few people – unless they're very wealthy – who can just live off the income in their portfolios."

This strategy does erode wealth, but it does so in a clear, controlled and sustainable way without taking on too much risk that could lead to larger capital losses in the event of a downturn.

Video: Money Monitor: Breaking down smart beta ETFs (The Canadian Press)
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