Bonds have long been the solution for investors seeking capital preservation and reducing portfolio volatility. But falling interest rates have made it tough to earn a fixed income return while preserving capital.
The current weighted average yield to maturity for the FTSE Canada Universe Bond Index is about 1.72%. According to Morningstar’s 2019 Global Investor Experience Study, the asset-weighted median expense ratio for Canadian fixed income mutual funds was about 1.49% for investors receiving commission-based advice. For investors in fee-based accounts, it was 0.85%, plus management fees (often another 1%).
The result is that many fixed income investors are paying fees that are comparable to the expected return from an investment grade bond, implying basically no net return after fees (let alone after tax and inflation).
Interestingly, the aforementioned bond index returned 8.68% in 2020—and not many people in the investment community, nor bond investors themselves, would have expected an almost double-digit bond return last year. So, what was the reason for that surprise? Bonds and interest rates move in opposite directions, and interest rates fell due to the pandemic.
In much the same way bonds rose in 2020 as interest rates fell, if interest rates rise, bonds will fall. The Bank of Canada made an interest rate announcement on April 21, and as expected, kept interest rates steady. However, they have accelerated their timeline for inflation returning to their 2% target to the second half of 2022, meaning interest rate increases could come as early as next year if growth continues to heat up.
As interest rates rise, bonds fall. In fact, if interest rates rose by 1%, Canadian bonds – as measured by the FTSE Canada Universe Bond Index—would drop by about 8%.
So, what is a bond investor to do? Paying 1% to 2% to earn 1% to 2%, while taking on interest rate risk, is chancy. Guaranteed investment certificates (GICs) from credit unions or trust companies may provide higher returns for really conservative fixed-income investors. Higher-yielding, lower-credit quality bonds with higher coupon payments and shorter maturities may provide better returns in a rising-rate environment.
There are alternative investments, like real estate and infrastructure, but these tend to have higher fees and poor liquidity, and may be difficult for retail investors to access. These are all riskier investments than investment-grade bonds and may not provide the same benefits.
Bonds are not just meant for return. They are also meant for reducing volatility as stocks go up and down, so in that regard, should not be excluded from a portfolio for a conservative or moderate risk investor simply because interest rates are low.
Some income-seeking investors focus on value stocks of big, established companies that tend to pay higher dividends. Historically, value stocks have generally outperformed growth stocks. However, over the past 10 years, the S&P 500 Growth Index has outperformed the S&P 500 Value Index in eight out of 10 years, returning 16.2% versus 11.2% annualized (as of March 31, 2021). Investors who focused on value stocks over the past decade may have underperformed growth investors or total stock market investors as a result.
Rising interest rates may have a negative impact on dividend stocks, as investors who have opted for dividends over bond interest reduce their risk level once again.
Investors who have a long time horizon for their savings, with many years to retirement, should probably have a healthy exposure to stocks in their portfolio. For conservative investors who are in their 60s, one of the best options for preserving capital in retirement is not an investment at all. It is an application (two, in fact).
Applicants for the Canada Pension Plan (CPP) and Old Age Security (OAS) pensions often apply as early as possible. For CPP applicants, that is age 60 and for OAS applicants, age 65. There may be a fear of missing out mentality that leads to early pension application. Some seniors apply simply because the application comes in the mail.
Deferring CPP or OAS pensions leads to an increase in pension income. After age 65, the increased pension is 7.2% for OAS pensioners and 8.4% for CPP pensioners. Recipients who live into their 80s, especially those with a lower risk tolerance, may benefit from deferring their pensions and instead drawing down their low-risk, low-return investments early.
As interest rates have fallen, the expected future return from fixed-income investments has also fallen. The formula for CPP and OAS pensions has not changed and, therefore, the relative benefit of deferring CPP and OAS has increased.
The most important thing for an investor to understand is what rate of return they need to earn. What is the impact of earning a 2% return compared to 4% or 6%? If someone can retire at a reasonable age or fund their desired retirement objectives based on a low rate of return, maybe today’s low rates are just a nuisance. But if conservative investing may inhibit someone from achieving their financial goals, they may need to consider forgoing capital preservation for higher returns.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
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