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Don't forget bonds
Investors must be selective

In the weeks following the 9-11 terrorist attacks, a few of my articles have stressed rational thinking and a need to always keep in mind the basics of portfolio design. Part of sticking to the basics is the inclusion of some exposure to fixed income, in one form or another, to provide some stability. However, with today's ultra-low interest rates, investors are wondering where to get that exposure.

Asset allocation guidelines for fixed income

Fixed income investments include things like (ranked from least to most aggressive within this category) cash (i.e. treasury bills, GICs, savings), government bonds, corporate bonds, and preferred shares. Unless otherwise noted, a reference to fixed income in this article refers to the total of all of those types of securities.

Bonds are a necessity and play two important roles in investment portfolios. Bonds provide an important stability element to portfolios by generating a consistent income. The income cushions the volatility of other investments. Also, bonds have the important job of diversifying away some of the risks of stock investing. As for how much you should have, that really depends on your specific rate of return requirements, your comfort level with risk, your time horizon, your tax bracket, and other factors affecting your asset mix. A good rule of thumb is to make sure to always have at least 20 per cent in fixed income.

Interest rate outlook

If you buy into the fact that you should have some fixed income exposure in your portfolio, the outlook for interest rates may have an impact on the type of fixed income securities you'll choose. The Bank of Canada lowered its overnight lending rate this week by three-quarters of a percentage point, down to 2.75 per cent. That is the lowest figure in forty years.

Given the current state of the economy, it is unlikely that interest rates will move much in any direction. Until there are clear signs that economic growth is really starting to gather some momentum, interest rates are unlikely to see any big moves. For a refresher on how governments use interest rates, revisit this recent article on inflation protection.

There are different theories on what influences interest rates. They range from today's yields having built-in expectations, to simple supply and demand factors, to expectations of future risk. Not one of these theories fully explains interest rate movements, though I would give more credence to the latter two. This isn't the place to get into a long and drawn-out discussion of interest rate projections, so I'll cut to the chase and say that short-term rates should rise substantially once the economic recovery arrives.

Over the past year or two, interest rates have really dropped on the short end of the spectrum, while longer rates haven't moved all that much. Hence, if rate hikes are eventually expected at the short end of the spectrum, holding a larger than usual cash position (which will benefit from rising rates) is a good strategy. This is best accomplished using high interest savings accounts offered by such institutions as ING Direct and PC Financial.

Direct bond investments

Buying bonds directly has natural appeal. There are usually no commissions to buy or sell; they offer guaranteed rates of return if held to maturity; and you don't have to pay any fees along the way. However, there are disadvantages to buying bonds directly.

While no commissions are explicitly charged, a larger investment will result in a more favourable yield. In other words, the commission is built into the yield quoted by the broker. Hence, comparison-shopping is a must.

Reinvestment risk refers to the fact that interest payments from bonds may be reinvested at a lower rate. That's not a big concern in this environment but in fact it would be a benefit if rates rise. What should concern the bond investor is the ability to reinvest interest payments. Unless the interest payments are sufficiently large, it may not be possible to efficiently reinvest them directly into other bonds.

Recall that the bond yield figures quoted in papers and online assume the reinvestment of interest payments back into the same bond. That's just not possible with conventional bonds. That's where stripped bonds (aka "strips") come in handy. Strips are basically bought at one price, and mature at a higher price - with no interest payments. They effectively allow bond investors to enjoy a compound return since there is no interest to reinvest. The only problem: with rates likely to rise, it's more beneficial to generate interest that can be reinvested - at presumably higher rates along the way.

If you buy bonds directly, don't spread things out too thin. Buying several maturities requires a bare minimum of $100,000 to $250,000 before it can be done efficiently.

Bond funds

Recall that rising bond yields (which is what I would expect) results in falling bond prices. That only matters if you want to sell before a bond's maturity. If you're holding until the maturity date, interim movements are irrelevant. In this environment, fees charged on bond funds should be a primary consideration in your choice of funds. For instance, consider the fact that government bonds carry yields ranging from a little over 3 per cent to just under 5.5 per cent. If you consider that the average Canadian bond fund charges 1.9 per cent annually, you've just given away one- to two- thirds of gross bond yields in management fees and operating expenses. Beutel Goodman Income , McLean Budden Fixed Income , Perigee Active Bond , and PH&N Bond , are my favourites in this category. All have management expense ratios (MERs) between 0.58 and 0.75 per cent per year and require minimum investments ranging from $2,500 (Perigee) to $25,000 (PH&N). In bond mutual funds, the saying "you get what you pay for" couldn't be further from the truth. Instead, it should be "you get to keep what you don't pay out in fees".

If you've decided you want exposure to corporate bonds and/or preferred shares, these are best entered into with the help of a full service stockbroker or via a mutual fund. Good funds emphasizing corporate bonds include PH&N High Yield , and Trimark Advantage Bond . My favourite preferred-share-heavy dividend funds are Dynamic Dividend , GGOF Guardian Monthly Dividend Ltd. Classic , and Spectrum Dividend.

Tax considerations

As much as possible, investments generating interest income should be sheltered in registered plans, like RRSPs and RRIFs. If your RRSP is small or non-existent, you may want to concentrate your fixed income holding in Canadian preferred shares. Dividends paid by Canadian companies are tax at a reduced rate. If your taxable income is under $30,000 dividends are taxed at an extraordinarily low 5 per cent marginal tax rate. Be careful though, too much dividend income could affect things like the non-refundable age credit for seniors and the refundable GST credit. The total net tax advantage of dividend income must be carefully examined.

Like all investment decisions, first decide on your asset mix strategy, then look at which investments best meet your risk and return expectations and fit your other constraints. Then look at how to maximize after tax returns.

Despite today's super low interest rates, fixed income still deserve a place in your portfolio. A lower than normal bond component and higher than usual cash position may be a good way to maintain some stability while still profiting when rates eventually rise.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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