National Post (National Edition)
WHY RISK IS NOW A BIGGER PART OF THE INVESTING EQUATION.
Low interest rates forcing different strategy
Last Thursday, when asked about the possibility of negative interest rates, Bank of Canada Governor Tiff Macklem responded that they are a tool the central bank could use in the event more needs to be done when it comes to addressing Canada's economic challenges. The bank already cut its key interest rate to 0.25 per cent in March and has indicated rates will remain low for at least the next two years.
This plan is not good news for retirees who live off of the returns generated from their savings. In the past, it was common to deploy one's retirement savings through a low-risk interest strategy, such as buying GICs. This worked great in 1990 when five-year rates were 11 per cent, and even 2000 when rates were at 5.3 per cent. Contrast this to today where one would be lucky to get one per cent from a Canadian bank.
For those looking to the bond market, it gets even worse, with five-year Canada governments currently yielding a paltry 0.38 per cent, down from 1.5 per cent at the beginning of the year. When adjusting for a more normalized but discounted CPI, this means real returns will likely be negative over the next few years, thereby accelerating the drawdown of one's wealth.
Investors do have other options, but they all involve having to onboard varying degrees of risk.
REAL ASSETS
For the past decade, Canadian investors have plowed money into real estate, which has offered attractive levels of income. The sector is only now starting to show the risks especially for those who choose the condo route. A surge in supply combined with a sharp drop in demand caused by COVID has sent rental rates crashing, leaving some with a negative carry despite low mortgage rates. So not only are they not making any money, some have no choice but to pay to keep a property that they are unable to sell without potentially undertaking a capital loss.
There are some well-run funds, though, with management teams that have expertise in managing portfolios of real assets. While most also have illiquidity risk, at least you are getting the benefit of diversification and some form of active risk management.
DIVIDENDS
Dividends can be a tax-efficient way to add yield to one's portfolio. Currently, the S&P/ TSX 60 index currently offers a 3.18 per cent dividend yield, which is quite enticing given where interest rates are at. There are also well-capitalized companies within the index that currently offer a yield in excess of five per cent.
However, these don' t come without significant risk. For some perspective, the index crashed by more than 35 per cent during the March COVID-19 sell-off. The good news is for those who stayed the course is that it has since recouped more than 90 per cent of its losses. But there were no doubt those who couldn't stomach the correction and locked in those losses near the bottom.
STRUCTURED NOTES
These are senior unsecured debt obligations of a financial institution whereby they are designed to provide some form of asymmetrical payoff profile or yield linked to the performance of a particular index. They can offer varying levels of principal protection, price appreciation potential and income. Many utilize options in their design, but because they are held within a note they are simplified in their structure.
For example, we recently structured a Callable Equity Income Note linked to a Canadian Large-Cap Index. It will pay a quarterly dividend equivalent to a 4.45 per cent annual yield as the index has not dropped more than 60 per cent from its issue level. It is callable semi-annually if the index is in positive territory, meaning there is the potential of only getting 6 months of interest (2.22 per cent). However, this rate is still much better than a GIC or Bond. Notes are not without their risks as most are not very liquid, not covered by CDIC, have credit risk by the issuing bank, are not tax efficient and still contain market risk. Therefore, diligence and using an adviser who understands these products is recommended before deploying such a strategy.
In conclusion, in today's ultra-low interest-rate environment, investors have few options other than to seek out higher risk alternatives if they want to meet their income objectives. It is imperative to understand all of the risks and the rewards when doing so.
Financial Post
Martin Pelletier, CFA, is a portfolio manager at WellingtonAltus Private Counsel Inc. ( formerly TriVest Wealth Counsel Ltd.), a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax and estate planning.