New risks for fixed-in­come

With in­ter­est rates be­gin­ning to inch higher after ul­tra-low lev­els over the past sev­eral years, gen­er­at­ing de­cent re­turns from a fixed-in­come port­fo­lio re­mains a chal­lenge

Investment Executive - - BYB: RETIREMENT - l BY MEGAN HARMAN

fixed-in­come plays an im­por­tant role in a re­tiree’s port­fo­lio. This as­set class’s rel­a­tive pre­dictabil­ity, com­pared with the po­ten­tial volatil­ity of equities, pro­vides com­fort. How­ever, in an en­vi­ron­ment of low in­ter­est rates that are just be­gin­ning to rise, the fixed-in­come por­tion of a port­fo­lio now car­ries ex­tra risks and chal­lenges.

A glob­ally di­ver­si­fied ap­proach to fixedin­come in­vest­ing is key to man­ag­ing risk while gen­er­at­ing worth­while re­turns for re­tired clients, says Darcy Briggs, vice pres­i­dent and port­fo­lio man­ager with Franklin Bis­sett In­vest­ment Man­age­ment, a di­vi­sion of Franklin Tem­ple­ton In­vest­ments Corp., in Cal­gary: “We be­lieve a well-di­ver­si­fied, l ow-cor­re­lated type of fixedin­come port­fo­lio is best for all types of en­vi­ron­ments.”

With in­ter­est rates at ul­tra-low lev­els for the past sev­eral years, gen­er­at­ing a sat­is­fac­tory level of re­turn from fixed-in­come in­vest­ments has been a chal­lenge. Now, in­ter­est are rates be­gin­ning to inch higher. The Bank of Canada (BoC) in­creased its bench­mark in­ter­est rate twice in re­cent months, and more hikes are an­tic­i­pated.

The prospect of higher in­ter­est rates is wel­come among re­tirees who have been frus­trated with the dis­mal re­turn on many fixed-in­come in­vest­ments in re­cent years. But ris­ing in­ter­est also may take a toll on clients’ ex­ist­ing fixed-in­come hold­ings, be­cause bond prices of­ten de­crease when rates rise.

“Within a year or two or three, you’re likely to see stronger re­turns [on new bonds],” says Adrian Mas­tracci, senior port­fo­lio man­ager with Ly­cos As­set Man­age­ment Inc. in Van­cou­ver. “But that means that if you hold bonds [now], you may lose some cap­i­tal.”

Briggs an­tic­i­pates that the BoC will in­crease its key in­ter­est rate once more in the short term. Be­yond that, he says, in­ter­est rates are likely to re­main near their current lev­els for some time, un­til there’s a mean­ing­ful rise in in­fla­tion.

“We don’t think in­ter­est rates are on a steady march higher,” Briggs says. “I think we’re get­ting close to what we may con­sider to be a peak for the time be­ing.”

None­the­less, po­si­tion­ing your clients’ port­fo­lios for the pos­si­bil­ity of in­ter­est rate in­creases is a good idea now.

Di­ver­si­fi­ca­tion is key to man­ag­ing risk, ac­cord­ing to Daniel Solomon, chief in­vest­ment officer and port­fo­lio man­ager with NEI In­vest­ments, a di­vi­sion of Toron­to­based North­west & Eth­i­cal In­vest­ments LP. Be­cause Canada’s fixed-in­come mar­ket is too small to al­low for proper di­ver­si­fi­ca­tion, he says, look­ing in­ter­na­tion­ally for in­vest­ment op­por­tu­ni­ties is cru­cial: “Canada’s fixed-in­come mar­ket has sim­ply too much in­ter­est rate risk and not enough di­ver­si­fi­ca­tion. Be­ing glob­ally di­ver­si­fied is safer.”

Branch­ing out­side Canada opens up a much wider va­ri­ety of govern­ment and cor­po­rate bonds, as well as cer­tain cat­e­gories of assets that carry the po­ten­tial for higher re­turns and are less com­mon in Canada’s mar­ket, such as high-yield bonds and in­fla­tion-linked bonds. Emerg­ing-mar­ket bonds and the op­por­tu­nity to man­age cur­rency also present some at­trac­tive global op­por­tu­ni­ties for fixed-in­come in­vestors, ac­cord­ing to Solomon. Mu­tual funds such as NEI Global To­tal Re­turn Bond Fund pro­vide op­tions for re­tired clients to in­vest in a glob­ally di­ver­si­fied bas­ket of fixed-in­come se­cu­ri­ties, he adds.

Cor­po­rate bonds also can be an at­trac­tive op­tion, as they can act as a cush­ion against an un­ex­pected move in in­ter­est rates, Briggs adds. Ris­ing in­ter­est rates gen­er­ally re­flect stronger eco­nomic per­for­mance, which can im­prove fi­nan­cial per­for­mance and bol­ster the cred­it­wor­thi­ness of cor­po­rate bond is­suers.

As a re­sult, cor­po­rate bond prices typ­i­cally de­pre­ci­ate at a much slower pace than govern­ment bonds when in­ter­est rates rise and, in some cases, cor­po­rate bond prices will in­crease.

Al­though some re­tired clients may view guar­an­teed in­vest­ment cer­tifi­cates (GICs) as a safe op­tion th­ese days, Solomon cau­tions against us­ing them. With GIC rates at such low lev­els after ac­count­ing for taxes and in­fla­tion, many clients will lose money.

“Most of the time, you end up with a neg­a­tive re­turn,” Solomon says. “That’s not a way to grow money.”

Aban­don­ing fixed-in­come in favour of equities, how­ever, may not be ad­vis­able, even if clients are un­happy with fixedin­come’s re­turns. Main­tain­ing an as­set al­lo­ca­tion through­out re­tire­ment that re­flects the client’s risk tol­er­ance is key.

“There’s a ten­dency at this time in the [busi­ness] cy­cle for in­vestors to be­come overly greedy, want­ing more re­turns,” Solomon says. “How­ever, when a down­turn comes, they re­al­ize that their risk ap­petite was lower than they thought it was.”

For clients who are wait­ing for higher in­ter­est rates be­fore wad­ing back into the fixed-in­come mar­ket, Mas­tracci rec­om­mends tak­ing a grad­ual ap­proach and buy­ing some each year rather than jump­ing in all at once.

“Jump in slowly,” he says. “Do it over three years or five years.”

“C anada’s fixed-in­come mar­ket sim­ply has too much in­ter­est rate risk and not enough di­ver­si­fi­ca­tion”

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