Thursday, 21 September 2017

Interest Rates and the role of Bonds/Fixed Income in your portfolio

With global interest rates beginning to rise due to central bank unwinding their balance sheet and low interest rates policies, this is indeed positive news for retirees, prospective retirees or investors seeking a safe haven from the volatility in investing in equities. Mind you, I think we are still in the early stages of a rising interest rate environment. Based on historical evidence, equities will continue to do well in the initial stages of rising interest rates (due to indication of economic growth).
As you know, the stock price is based on the present value of future cash flows on a company discounted using current interest rate. As rates increased, assuming everything else remaining constant (ceteris paribus), the price of the stock decreases.

Bank of Canada has increased rates twice already this year. The Government of Canada 10-year bond has spiked to 2.1%, which is the highest since late 2014.  As seen in the Canada 10-year bond chart below, the highest rate in the past 5-years was 2.8% in December 2013.  My prediction is that there will be at least 3 or more rate hikes by the end of 2018.  The U.S. is on a similar trajectory. The E.U.and  the United Kingdom have indicated an end to the easy monetary policy, but have yet to officially raise interest rates.  

From a portfolio allocation standpoint, my suggestion would be to start increasing exposure to fixed income (or bonds), and stay in the mid-end of maturity (no more than 10 years). Duration is the key measure of a bond’s sensitivity to changes in interest rates.  For example, if the duration is 5, this means that the price of a bond will increase by 5% if yield decreases by 1%.  Note that price of bond is inversely related to yield.  Conversely, the price of a bond will decrease by 5% if yield increases by 1 percent.

A sample corporate bond from Brookfield Asset Management below , which as an investment grade rating of A1 and maturing approximately 10 years from today yields 3.72%, or 150 basis points higher than a 10-year Government of Canada bond.  

If you stagger your bond maturities and purchase an equal amount of 3-year bond from Hydro One that yields 1.92% as you did with Brookfield 10-year bond above, your weighted average yield on your bond portfolio would be 2.82% . rough estimate of Duration would be approximately 6 years.  Since rates are expected to continue to rise, you would do well to stay at that duration level.

One may question why invest in bonds that yield less than 3% on average when rates continue to go up.   One can easily buy dividend paying stocks that yields more than 3%.  The biggest reason for purchasing bond is the peace of mind that bonds provide during uncertain times. Case in point, during the 2008 market crisis, a 40% allocation to government bonds specifically would have cushioned your portfolio losses by more than half.  

Another reason is that bonds typically pay more than the interest provided by banks.

Lastly, bondholders typically have priority over stockholders if a company goes bankrupt.  Hence, the dividend or more importantly, the principal amount invested in the common stock may not be totally safe.

My ideal portfolio will provide a return of 6% consisting of 60% Equity, assuming return of 8% and 40% Fixed Income assuming Return of 3%.  Returns above are assumed to be net of inflation and investment fees.  I know people are going to balk at that return and will probably say that investing in Facebook or Amazon alone can quadruple the 6% above.  I challenge anyone who can do this consistently, though. More important than the 6% return is that the portfolio above can reduce the volatility of your portfolio by reducing the expected standard deviation of returns. In other words, you have a better change of achieving a 6% return on average than hitting a home run consistently.

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