Why to choose fixed income as rate risk subsides

As the Bank of Canada (BoC) and Federal Reserve become more dovish, with further interest rate hikes less likely this year, fixed income will provide opportunities for investors.

“Inflation is the key driver of interest rates,” says Catherine Heath, vice-president and portfolio manager at Leith Wheeler in Vancouver. “Inflation in Canada is below the BoC’s target of 2%. So with inflation in check, rates will rise only modestly.”

Joey Mack, director, fixed income at GMP Securities, agrees. “Rising rates have been the real driver of weakness in the bond market. We should not see any more increases in short-term rates this year. I now think you’re going to see true bond-like returns in the area of 2% to 3% for 2019.”

For fixed-income investors, stabilizing rates should mean better returns. However, return after inflation will be an ongoing challenge, depending on the investment.

“GICs and Treasurys don’t necessarily yield much return after inflation,” says Geoff Castle, portfolio manager at PenderFund Capital Management Ltd. in Vancouver. “If I bought a five-year Government of Canada bond, it would yield 1.8%. So if you’re trying to make money after inflation, you’re not getting off to a good start.”

The average of the BoC’s core inflation readings was 1.9% in December. When the central bank held the overnight rate at its January meeting, it said the rate “will need to rise over time” to its neutral range of 2.5% to 3.5% “to achieve the inflation target.”

Still, Castle says inflationary pressures have begun to fade and fixed-income investors should see better returns.

But before adding fixed income to an investor’s portfolio, it’s important to understand common mistakes. Here are three to avoid.

• Trying to time the market

Investors often follow the news, trade on yesterday’s market and, as a result, miss out on opportunities.

“When something has gone down recently, they tend to be afraid,” says Castle. “And when something’s gone up recently, they tend to be excited.”

Mack adds that whether you’re investing in bonds or stocks, trying to time the market is a bad strategy. “You don’t have any track record of any managers being successful interest-rate timers. So stick with your discipline. Don’t hesitate to buy today in the hopes you get something better tomorrow.”

A low-cost, passive strategy, such as laddering, indexing or a bullet, will outperform strategies based on timing interest rate or price moves, he notes.

“The one exception when trading in fixed income is avoiding credit events,” adds Mack. “If you hold corporate bonds, and the company’s performance is deteriorating, then you want to protect your capital and sell.”

• Reaching for yield

A big mistake that Mack sees is investors focusing on yield. “People will buy lower-quality credit just because it has an attractive yield. That yield is there for a reason—it reflects risk.”

He adds investors should limit their high-yield exposure to a maximum of 10%. “A high-yield bond can act a lot more like equity over the long run. It doesn’t provide the diversification and income you need when you need it, and it tends to attract pricing close to equity. High-yield should be a subset of equities and risky assets, not a subset of the ‘safe’ bond portion of your portfolio.”

• Not understanding volatility

Often, investors think fixed income isn’t susceptible to market volatility. But Heath explains that’s not true.

“Sometimes there’s an expectation that you can’t lose money on bonds,” she says. “But on a mark-to-market basis, interest rates fluctuate every day. So it’s normal to see bond prices rise and fall on a daily basis.”

For government bonds, the key for retail investors is to hold to maturity. “You should always receive your principal back and collect your coupons over that time period.”

However, she warns this isn’t always the case for corporate bonds. “There is a risk of default; hence you may not get your principal back.”

Opportunities

Subsiding rate risk and inflationary pressures means that now is the time to choose fixed income. And experts agree that corporate bonds will be the sweet spot going forward.

As Castle noted, the 1.8% yield on a five-year Government of Canada bond barely covers inflation.

A senior bank bond gives investors around 2.6%, Heath says. “It’s a pretty decent pick-up for a low level of risk. And these are the highest level of the capital structure, so you’ve got pretty good protection and low risk of default.”

Looking further down to triple-B bonds, a five-year Bell Canada bond would return about 3%, she says. “At 3%, you’re covering your inflation. So you’re protecting the purchasing power of your investment, and you’re getting a little bit more.”

Returns on 10-year investment-grade triple B or better-rated securities are around 4%, says Mack. “That’s pretty attractive right now, especially since you can buy these bonds at a discount.”

Before investing, ensure clients leave room for margin of error, warns Castle. “If things for the company don’t go as well as you’d hoped, there should still be enough buffer in terms of equity valuation, cash and liquidation value, so that you’re not risking losing your principal in the bond.”

Also, the yield must be reasonable with respect to inflation, he says. “You need to think about what is this company going to look like on the day the bond matures? Will it have resources that allow it to pay off the bond in the event of default? Will it have enough cash flow in order to refinance the bond?”

No matter where clients choose to invest in the fixed-income space, the key is to stay the course.

“Look back over the last 20 years,” says Mack. “A 50/50 bond-and-equity portfolio would’ve done almost as well as a 100% equity portfolio, with way less volatility. So don’t stay underweight fixed income, especially where we are in the market today. It makes sense to put your cash to work in fixed income and take some equity money off the table.”