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September 22, 2016 | Portfolio management

A best-selling Canadian author of 14 books on economic trends, real estate, the financial crisis, personal finance strategies, taxation and politics. Nationally-known speaker and lecturer on macroeconomics, the housing market and investment techniques. He is a licensed Investment Advisor with a fee-based, no-commission Toronto-based practice serving clients across Canada.


Let’s imagine the impossible for a minute. You read this blog. It speaks to your inner soul takes you to a better place. You know you need to invest. You agree in a balanced, diversified, liquefied state of Zen. But now you face a dilemma.

Yes, bonds are safe and you need steady stuff to preserve capital. But they pay almost nothing, and become less valuable when interest rates start to rise. What to do?

Well, as Yogi Berra said, when you come to a fork in the road, take it.

Just to be clear, a 60/40 portfolio (the kind that arouses me) has 60% in growth assets and 40% in fixed-income. Most people think this means “stocks” and “bonds”. But it doesn’t. Just as the growth portion is highly diversified (equity-based ETFs investing in Canadian, US and international markets – large, medium and small-cap companies – plus real estate investment trusts), the safe portion of a healthy portfolio is also a mix of stuff.

Yes, bonds pay nothing – at least government bonds. Central banks have hammered interest rates into the dust, seriously penalizing savers and (as detailed yesterday) forcing people to shift their retirement strategies. So why own any?

Simple. Stability. Anti-volatilty. Anchoring your portfolio. For example after UK electors surprised everyone and voted themselves off the continent, global stock markets careened lower for a few days, robbing the S&P 500 of about 6% of its value. Ouch. But Brexit also caused bond prices to spike, since billions of worried dollars flowed into these safe havens. So while the yield on the bonds was unchanged, the value of the bonds jumped – which helped to offset the drop in equities. When stocks were off six per cent, a 60/40 portfolio was down only about 1%, and quickly recovered.

Thank you, bonds. If the nutcase wins the White House, expect a similar story.

But yield is still a goal of any investor, so the 40% fixed-income portion needs to cough up more than government bonds deliver. Thus, if your portfolio is big enough (a few hundred grand) you should also have some corporate bond exposure – investment grade debt (like that issued by the banks or insurers) – which pays a higher yield and is quite safe. Ditto for provincial bonds, with zero default risk and delivering another 40-or-so basis points in yield.

Finally, don’t forget about inflation. It’s a fact of life, especially with a sea of debt swirling around us and an anemic dollar boosting import prices. So having some real-return bonds is a good idea, because the effective yield actually increases along with the rate of inflation, plus they’re guaranteed by the feds.

All of the above should end up equaling about half of the 40% making up the safe portion of your overall portfolio. (And remember to move stuff around so that interest-bearing assets like bonds are safely ensconced inside your RRSP tax shelter.) But does this mean you have to go and find actual bonds to purchase? Nope, there are lots of exchange-traded bond funds around that will do the job.

So what of the other half of the forty? That’s where the preferred shares come in. These are a hybrid of stocks and bonds. Like stocks they pay dividends and give you an ownership stake in the company. Like bonds they’re far less volatile than common stocks, with quarterly cash distributions. The income stream is also safer, which is why they’re ‘preferred.’ A company in difficulty might trim the dividend for its common stockholders, but cannot reduce it on the preferred shares.

Most preferreds today are rate-reset, so they lose capital value when rates drop (that happened last year) and gain value when rates rise (that comes next year). But in the meantime they pay a great dividend – currently a tad over 5%. Try to find that anywhere else with an asset that’s 100% liquid – and which comes with a tax credit. So while interest is 100% taxed at your marginal rate, preferreds pay dividends that have a preferential tax treatment. Yes, because they’re special. Like you.

So the preferreds (at 20% of the overall portfolio) give you a great yield boost, making the overall return on the safe, fixed-income portion equal 4% or a little better. If stock markets do nothing, in other words, you’re still beating the pants off a GIC, and doing it with less tax. Again, there are a few great ETFs around providing exposure to a basket of quality Canadian preferreds. And ignore the know-it-alls who come here to tell you prefs are bad because the capital value fell as rates were reduced.

So what? You buy them for yield and security of income, plus lower taxes, not for a capital gain. Having said that, with rates at the bottom of the curve, it’s hard to see how investors taking a position in preferreds today will not be happy dudes in the years to come.

Well, there you go. And you though fixed income assets were boring. Shut up.

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September 22nd, 2016

Posted In: The Greater Fool

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