The incredible volatility that stock markets around the world have experienced over the past few years has reinforced the importance of holding some low-risk assets with predictable returns in your portfolio. Traditionally, fixed-income investments have filled this bill, and I think they still do.
However, in today's world of financially engineered fixed-income products that many investors don't understand (asset-backed commercial paper anyone?), it's essential to choose carefully. What, then, are the best choices for this boring but essential asset class?
The venerable five-year laddered strategy, based on five guaranteed investment certificates (GICs) with five different maturities, is one simple solution.
Here's how it works: Divide your fixed-income allocation into five parts. Invest one-fifth in each of one, two, three, four and five-year GICs. When the oldest GIC matures, reinvest the money in a new five-year GIC. Repeat. Boring!
GIC ladders are often given short shrift by financial advisors and investors alike. Even so, they may be the best choice for conservative investors. Here's why:
Clearly, the safety and risk-management aspects of GIC ladders are indisputable. But what about returns? A five-year GIC ladder invested at the best rates currently offered by my discount broker (as of mid-June) with each maturing GIC reinvested at the five-year rate (3.7%) would deliver a 3.41% compound interest rate over the five years.
In a rising interest-rate environment such as the one we are now entering, a GIC ladder offers the opportunity for better longer-term compound returns. These are illustrated in the hypothetical scenario below, which assumes rising rates:
No rate increase
(maturing GICS reinvested at 3.7%)
1% rate increase in year 2 to 4.7%
1% rate increase in year 3 to 4.7%
0.5% increase in year 2
Another 0.5% increase in year 3
Investing directly in bonds is another fixed-income option, albeit one with more risk than GICs. If you go this route, focus on high-quality bonds like Government of Canada issues. Bonds issued by the provinces, Crown corporations and blue-chip corporations are also reasonable choices and have slightly higher interest rates. As with GICs, you'll want to ladder the maturity dates of your bond holdings.
Unlike stocks, bonds do not trade on an exchange, and the sales commission is bundled into the bond's price. So it's difficult for a retail investor to know if the commission is reasonable.
You can get an idea of current wholesale bond prices at www.canadianfixedincome.ca or www.canadianbondindices.com. Your broker might tell you the commission rate if you ask. It makes sense to hold bonds to maturity to keep these hidden transaction costs low.
Retail investors may never get their hands on the best bonds, which are scooped up quickly by institutional investors. This, along with the fact that the commissions are not easily determined, suggests that the bond-investing decks are stacked against the retail investor.
The best alternative may be to let a mutual fund or exchange-traded fund (ETF) manager do the job for you. Look for a fund with:
For bond ETFs, in particular, look for one whose market benchmark is a well recognized index of high-quality government and corporate bonds. (Currently, the only fixed-income ETF in Canada which has at least a five-year track record is iShares DEX Universe Bond Index.
Opting for a mutual fund or ETF rather than holding bonds or GICs directly can make quite a difference in your returns, for better or worse. Here's a snapshot of historical returns for the five years ended May 31:
|Average 5-year GIC||2.7|
|Average Canadian Fixed Income mutual fund||3.7|
|Median Canadian Fixed Income mutual fund||3.7|
|iShares DEX Universe Bond Index||4.5|
While the returns for the mutual funds and ETF were higher than those of five-year GICs, investors need to remember that when interest rates increase, bond prices fall. In our current rising-rate environment, declining net asset values of bond funds and ETFs are likely to erode returns.
Meanwhile, returns available on newly purchased bonds and newly issued five-year GICs should be higher, reflecting rising interest rates.
One final point to factor into your fixed-income planning is protection against inflation. The solution: invest a portion of your fixed-income holding in real-return bonds, either directly or through an inflation-protected bond fund or ETF.
The Great Recession of 2008 reacquainted investors with the concept of investing risk. It served as a reminder that low-risk fixed income -- whether in the form of GICs, bonds, bond mutual funds or bond ETFs -- deserves a permanent place in the portfolio of virtually all investors.