Fixed income is an asset class that offers a steady stream of income and is considered to have less risk than stocks (i.e. equity). Fixed income is used by investors to generate income and protect their capital. The most popular method of high-quality fixed income investing is purchasing government and/or corporate bonds.
Fixed income has always been a fundamental component of a diversified investment portfolio. Its traditional role is to hedge equity risk exposure so that you still have income in case of a market downturn. When we look back at previous market cycles, we can see that this has indeed been true. This inverse relationship between equity and fixed income is now being called into question. Interest rates are currently at historical lows and the major Central Banks are signaling that they plan to keep interest rates low well into the future.
With interest rates at historic lows and the very probable prospect that they will be lower for the long term, investors are preparing for a new market environment where bonds may no longer provide the ballast and diversification they previously did. If we assume this is the case, then the question is – where do you go for yield?
The following chart is a high level summary of available options within Fixed Income along with interest rate expectations as of the date of this publication:
| wdt_ID | Fixed Income Options | Interest Rate Expectations | Benefits | Risks |
|---|---|---|---|---|
| 1 | Gov't of Canada Marketable Bonds | 0.23%1 | Low credit risk, considered to be “risk-free”. Very liquid. | After factoring for expected inflation, the real rate of return is likely negative. |
| 2 | Government Bonds (Provincial) | 0.25 - 1.7%2 | Low credit risk and very liquid. | After factoring for expected inflation, the real rate of return is likely negative. |
| 3 | GICs | 0.1 - 1.85%3 | Generally are liquid but if cashed before maturity are subject to a fee. | Credit risk is dependant on the issuer. Riskier than Government bonds and only guaranteed to a limit (usually $100,000). |
| 4 | Corporate Bonds (Investment Grade) | 3.06%4 | High credit rating issued by a leading credit rating agency. Pay a higher interest than Government Bonds and GICs. Generally has good liquidity. | Credit risk is dependant on the issuer. They are risker than Government Bonds & GICs, but have a high credit rating, putting them in the Investment Grade category.Foreign currency risk associated with non-Canadian issuers. |
| 5 | Corporate Bonds (Below Investment Grade) | 3 - 5% | Pays a higher interest rate as a result of its low credit rating. | Below-investment grade credit rating issued by a leading credit rating agency, making it higher risk. Liquidity can also be a challenge, especially in a down market.Foreign currency risk associated with non-Canadian issuers. |
| 6 | Mortgage Funds (Residential) | 7- 8% | Pay a higher interest rate. Credit risk is mitigated by a registered lien on residential property. Most are able to offer quarterly liquidity. Not correlated to public markets. | Private funds are not rated and therefore investors must rely on the local real estate market where the fund issues the loans. |
Notes:
1: 1 to 3 year average yield per Bank of Canada website as of Mar 29/21.
2: short-term to long-term rates.
3: 1 year to 5 year per RBC.
4: Moody’s Seasoned Aaa Corp Bond Yield.
Other Options:
- Private Credit Funds (Closed end funds)
Investors who are able to access the private market may choose to invest in closed end funds. These funds typically have a high minimum investment (usually $1 million or more). These funds target interest yield in excess of 7%. Closed end funds are not liquid and as a result, investors must commit to locking up their money until the end of the investment term (generally between 5 to 10 years). Essentially investors trade off liquidity for an expected higher return. Risk will vary depending on the investment strategy, typically these funds tend to be higher on the risk spectrum as transparency is limited and performance is dependant on the manager’s underwriting expertise. - Preferred Shares
Investors are increasingly turning to preferred shares as an alternative to bonds. Although they are equity in nature and pay dividends (not interest), they offer bond like characteristics if they offer a fixed dividend. They tend to be liquid if they are publicly traded. They vary in risk, depending on the company profile and the dividend yield should be matched to the risk by investors or advisors. - Dividend Stocks
It may sound counter-intuitive to invest in a stock if the goal is to diversify away from equities. However, in the search for yield, more investors are looking to high-dividend paying stocks that behave like fixed income. Certain “Blue Chip” companies with a long history of consistent earnings who pay most of their earnings to investors as dividends, have been able to attract some fixed income investors who classify high paying dividend stocks as “bond-like”.
There are still places to find yield, despite this new low interest rate environment which is likely to persist well into the future. With inflation expected to rise (Central banks are targeting 2% annual inflation), investors should consider “real returns” which is the return after adjusting for inflation. In the past, Government Bonds and GICs were heavily used by investors to provide ballast and diversification. It is highly questionable that they can be used for the same purpose going forward. Corporate Bonds, Mortgage Funds and other Private Funds may be a good source of higher interest rates and investors should continue to consider their investment horizon and risk tolerance, seeking appropriate advice, to determine how to position fixed income with their portfolio in this new world of low interest rates.
