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My bond ETFs have plunged but I like the income. Should I sell?

The percentage of our portfolio that is fixed income is 51%, cash 10%, equities 39%. Is my reasoning valid?

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Dear Nancy Woods,

I and my wife are in our late seventies; we hold a 7 figure portfolio. We hold a large position in iShares 20+ year treasury bond ETF (TLT) and Vanguard Long-term Bond ETF BLV, which both have suffered a significant fall recently. I had anticipated the risk earlier and rationalized on the basis that we would continue to receive the interest payments regardless of a likely capital loss. The interest payments although low as a percentage are sufficient for our needs, and because they are from 20 year + bonds will continue for the rest of our life. The percentage of our portfolio that is fixed income is 51%, cash 10%, equities 39%. Is my reasoning valid?

Peter

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Dear Peter,

The amount of fixed income you have in your portfolio, currently 51%, during a "normal" interest rate environment would seem reasonable. However, during the historically low interest rate environment we are presently in, I have found that following the traditional guideline of '100% less your age' as your equity exposure is not particularly appropriate.

Simply said, the government's target inflation number is 2%, so an investment that you purchase which yields you less than 2% means you are effectively losing money. Typically, that is not the goal. There are those with the temperament who cannot stomach the possible risk of losing money, yet they do not consider the loss of buying power of a dollar due to inflation. The yields on your two large bond funds are above the 2% hurdle; however the interest rate sensitivity that they have can negate the income when interest rates rise. (When interest rates rise, all things being equal, bond prices go down and vice versa).

There are some things that you and your wife need to consider. I understand how you would think that investing in these long term bond funds and only expecting to collect the income would be attractive to you. In your mind you do not anticipate selling in the future even with the eventual certainty that interest rates will go up and therefore the value of your bond funds will decrease. I say "eventual certainty" with a grain of salt, because we do not know when that will happen; it could be in the next couple of years or not happen for a decade. Whenever it does happen, when you and your wife pass away your estate could be in for a significant capital loss. If you are not looking to preserve the assets of your estate as best you can, then carry on as you are. If you are of the mindset that you want to reduce this risk then you need to evaluate your holdings in the long term bond funds. It may only involve reducing the average maturity profile of your portfolio to include shorter term bond funds. You may also consider owning individual bonds, stripped coupons or GICs.

You ought to also consider increasing your equity exposure or simply buying a ladder of maturing GICS. The GICs insure that your capital will be intact upon maturity. There are many Canadian equities that have a history of solid dividend payments (and dividend increases) and some growth potential. The dividend tax credit certainly enhances even the lowest yield.

All in all, since you are comfortable spending your capital, I would have you consider a redesign of your portfolio to better suit our current times.

Nancy Woods is an associate portfolio manager and investment adviser with RBC Dominion Securities Inc. Visit her website www.nancywoods.com or send an email request to asknancy@rbc.com. You can also send your questions to asknancy@rbc.com.

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