Embracing bond strategies

Have you ever had the feeling something wasn’t quite right but couldn’t pinpoint the reason? My four-year-old son and his friends recently found my electric razor and used it to shave my son’s left eyebrow. My wife and I stared at him on and off for hours before we figured out what was wrong with our kid.

Even worse is a situation where you know something’s wrong, but it’s been that way for so long you don’t even think to change your habits. When the light bulb above your head finally does go off, though, you look back and wonder why you didn’t change earlier, or avoid the situation altogether.

Where am I going with this? I may not make a lot of friends with this comment, but I think we need to revisit the way we invest our clients’ fixed-income investments.

And here’s why: The biggest part of the baby-boomer bulge will be retiring over the next decade. This is likely going to cause a systemic shift to higher bond allocations for those who control the assets in this country and, by extension, the large portion of advisors’ businesses. With interest rates at historic lows, taxes seemingly always rising, and the investment outlook uncertain (even for bonds), advisors must evaluate whether the commonly used bond-ladder strategy is still the best option.

Interest income vs. capital gains

Let’s start with the elephant in the room: tax rates on income. Currently, the highest marginal tax rates on income in Ontario are at 44%, while capital gains are taxed at 22%. The reality for us all is you can only spend after-tax dollars.

So why would we subject our clients to a tax rate of 44% when we can reduce it to 22% – or perhaps even less? This can be done through allocations to funds in open accounts that are invested in tax-efficient corporate-class structures. Yet despite the obvious benefits, the utilization rate of such a strategy is surprisingly low. Corporate-class structures allow bond investors to convert interest income into capital gains. And by applying gains made from a fixed-income pool within a corporate-class structure to past losses, you can potentially reduce a client’s tax payable to zero; something you just can’t do with interest income.

Take the example of an individual in the highest tax bracket in Ontario, with a $500,000 bond portfolio that’s distributing 4%. That investor would experience an after-tax bond equivalent yield of almost 7% by using a corporate-class structure. For a bond mutual fund that’s charging between 50 and 75 bps (F-class), the value added purely from the corporate-class structure would more than pay for itself. Try finding a collection of bonds in today’s market yielding 7%. It’s simply not doable unless a client takes significant credit risk – something most just aren’t willing to do. There may also be other benefits for today’s clients, taking into account capital losses they may have accumulated from 2008.

Active bond management

In a rising interest rate environment, the ability to adjust the portfolio to take advantage of opportunities and avoid pitfalls doesn’t exist in a bond ladder. Over the past 20 years, in a consistently falling interest rate environment where buy-and-hold bond investors were rewarded time and time again, this hasn’t been a concern. However, today’s volatile and potentially rising rate environment will call for active fixed-income strategies.

For instance, an actively managed bond fund provides the ability to become more defensive, if need be, by adjusting the interest rate sensitivity of the portfolio when interest rates are rising. With a bond ladder, though, it’s much more difficult to react to changing market conditions because of: Much higher transaction costs (to sell existing bonds and buy new ones) when adjusting the duration and maturity profile of the bond ladder; and the much lower level of diversification within a bond ladder.

If fixed income represents 40% to 65% of an investor’s portfolio, with yields as low as they are now, a passive fixed-income investment may not earn enough to meet a client’s return objectives. A client can no longer afford to have the fixed-income portion of the portfolio be simply an afterthought.

In a low-yielding environment, any extra return you can generate from the fixed-income portion of the portfolio (such as through an actively managed fixed-income pool) becomes even more critically important to helping the client achieve his or her long-term return and income objectives.

This is just one of the reasons why advisors should consider moving from passive bond ladders to actively managed discretionary bond portfolios or top bond mutual funds with reasonable MERs.

Corporate vs. government bonds

Last but not least, the bond landscape has changed in Canada. As recently as ten years ago, the overwhelming majority of bonds was issued by the various levels of government in Canada. Today, although government bonds still represent the majority of the bond market, their dominance has decreased. So bond investors now have to consider corporate bonds and other types of fixed income more often to fulfil their needs.

Perhaps more importantly, the decline in government bond yields has encouraged investors to seek higher yields in corporate bonds to maintain income needs. On the flip side, corporate bonds can be far less stable than their government counterparts. In 2008, for example, many experienced significant negative returns while spreads expanded to over 4% versus government bonds. And most will also agree the skill set required to manage a corporate-bond portfolio is not the same as needed for managing a government portfolio. Many corporate-bond managers liken themselves to equity investors, as they’re very focused on company-specific issues like the balance sheet, income statement and cash flow generated by the business. If you don’t analyze these micro issues properly, they could easily wipe out any return generated by the stated yield of the bond.

Think outside the bond box

Please don’t misinterpret my bond growling for bearishness on the equity markets. I’m simply contemplating an increase in bond allocation for demographic reasons – the aging of the baby boomers. My concern is for those clients who need to understand there are actually some risks when they decide to increase the bond allocation in their portfolios. The pushback I get from some advisors on doing anything but a bond ladder is clients feel comfortable with the idea that they can’t lose money as long as they hold the bond to maturity. But we as advisors know that’s not entirely true, though we perpetuate the myth for the sake of simplicity.

My retort is we in the investment business are often highly paid individuals. The reason for this is the great responsibility to do the best job possible to preserve and grow the wealth of our clients. We must explore all avenues to ensure our clients can live with dignity in their retirement years and enjoy the lifestyle they became accustomed to in their working years. So, we need to think beyond bond ladders and start talking about active bond-management strategies and tax-efficient, managed-yield fixed-income ideas. This higher level of fixed-income thinking can add value to clients’ portfolios – and our business goals – in the long run.

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Keith Pangretitsch is the director of private client services at Russell Investments Canada .

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