FIXED-IN­COME

Bond al­ter­na­tives may not be the an­swer to low yields.

Investment Executive - - FRONT PAGE - BY DAN HALLETT

de­spite the num­ber of ar­ti­cles I’ve writ­ten over the years that have a neg­a­tive or warning tone, I am no Danny Downer. There’s no point in writ­ing any­thing other than my can­did opin­ion. Still, I re­flected re­cently on my many neg­a­tive ar­ti­cles, con­clud­ing that my of­ten neg­a­tive tone is a func­tion of the pro­lif­er­a­tion of over­promises in our in­dus­try.

Per­haps the big­gest over­promise to­day is that of bond sub­sti­tutes. Bond yields re­main skinny de­spite ris­ing over the past year, which lim­its the re­turn po­ten­tial of bal­anced port­fo­lios. In re­sponse, many in­vestors and their fi­nan­cial ad­vi­sors are opt­ing to re­place some or all of their bonds with other cash flow-gen­er­at­ing in­vest­ments. Div­i­dend-pay­ing stocks and real es­tate in­vest­ment trusts (REITs) are pop­u­lar choices for higher-yield­ing and high­er­re­turn­ing al­ter­na­tives to bonds.

But th­ese choices just give in­vestors more stock mar­ket ex­po­sure and less di­ver­si­fi­ca­tion. And in­vestors for­get two things about th­ese equities that spin off in­come: 1. When the stock mar­ket hits the next bear mar­ket, both div­i­dend- pay­ers and REITs will take it on the chin pretty hard, in line with the broader mar­ket. In­come-pay­ing equities lost more than the broader mar­ket in Canada dur­ing the global fi­nan­cial cri­sis. They also ended 2015 in a hor­rid, 16-month stretch that pushed prices down by 22%. Cana­dian stocks, in gen­eral, were down by only about 14% dur­ing the same time frame. The post-2000 tech bust is the only ex­cep­tion to div­i­dend-pay­ers’ deep bear mar­ket losses. 2. Many in­vestors are un­der the mis­taken im­pres­sion that their div­i­dend-pay­ers will de­liver them just as much in cap­i­tal gains as the broader mar­ket — or more — on top of their div­i­dends.

Sup­pose that stocks are go­ing to de­liver, for ex­am­ple, 8% a year in the fu­ture through a com­bi­na­tion of div­i­dends, which are paid and rein­vested, and cap­i­tal ap­pre­ci­a­tion. That 8% fig­ure is the to­tal — not on top of div­i­dends. And, like War­ren Buf­fett’s Berk­shire Hath­away Inc., if stocks paid no div­i­dends, that 8% would be en­tirely in the form of share price in­creases. In other words, the div­i­dend might be a sig­nal of growth or cash-flow dis­ci­pline, but it’s part of the to­tal re­turn.

On the other hand, un­con­strained bond funds are bond funds in name, but have more sub­tle ex­po­sure to risky assets. One such pop­u­lar fund boasts a high sin­gle-digit re­turn this year. Its long list of po­si­tions not only in­cludes as­set-backed loan pools, private loans and emerg­ing mar­kets debt, but also a com­plex web of de­riv­a­tive po­si­tions. Some po­si­tions are straight­for­ward, such as short­ing bond fu­tures to re­duce du­ra­tion. Oth­ers re­quire dig­ging to con­tex­tu­al­ize. Ex­am­ples in­clude long and short cur­rency bets, re­verse/re­pur­chase agree­ments and long and short de­riv­a­tive po­si­tions (on credit and in­ter­est rates).

This fund of­fers mean­ing­ful ex­po­sure to i nvest­ment-grade bonds. How­ever, a sta­tis­ti­cal anal­y­sis of its per­for­mance re­veals that some 70% of its volatil­ity is linked to global stocks and high-yield bonds, which, in turn, are fac­tors that drive re­turns. Anal­y­sis also re­veals strong cor­re­la­tion to global stocks and high-yield bonds.

If you want more stocks to juice re­turns, just add stock ex­po­sure with your eyes wide open. But let’s not toss bonds aside en­tirely. Bonds are meant to pro­tect against equities’ bear mar­kets and pro­vide cash for re­bal­anc­ing when stocks are at a low point. Load­ing up on too many bond sub­sti­tutes will leave clients — and your book — more vul­ner­a­ble in the next bear mar­ket.

Per­haps the big­gest “over­promise” to­day is that of bond sub­sti­tutes

Dan Hallett, CFA, CFP, is vice pres­i­dent and prin­ci­pal with Oakville, Ont.-based HighView Fi­nan­cial Group, which de­signs port­fo­lio so­lu­tions for af­flu­ent fam­i­lies and in­sti­tu­tions.

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