Before last year’s underperformance of both bonds and equities, a 60/40 equity-bond portfolio traditionally averaged around an 8 per cent annual return.William_Potter/iStockPhoto / Getty Images
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With inflation stabilizing and last month’s interest rate hikes from the Bank of Canada (BoC) and U.S. Federal Reserve Board, some advisors are beefing up their bond positions in client portfolios by adding duration, but they’re also weighing the credit risk.
Mike Waller, portfolio manager at Lakeside Wealth Management with Investment Planning Counsel Inc. in Kelowna, B.C., says he believes the BoC is close to the end of the interest rate tightening cycle and sees bonds finally achieving respectable real return rates, which hasn’t been seen for years.
“We have been adding duration while still maintaining high credit quality companies because there isn’t a lot of spread in the high yield market,” he says.
An-Lap Vo-Dignard, senior wealth manager and portfolio manager with Vo-Dignard Provost Wealth Management Group at National Bank Financial Wealth Management in Montreal, says rebalancing portfolios is taking place for some clients whose equities performed well since the beginning of the year.
“The rates are at a point at which it could be interesting to look at bonds,” he says. “Never go completely in one direction or the other but increase the position.”
Andrew Feindel, portfolio manager and investment advisor with Richie Feindel Wealth Management at Richardson Wealth Ltd. in Toronto, is taking a pragmatic approach to bonds. Before last year’s underperformance of both bonds and equities, he notes that a 60/40 equity-bond portfolio traditionally averaged around an 8 per cent annual return, with equities doing the heavy lifting for many years. Therefore, bonds were not given a big showing in his client portfolios.
“Bonds have had a bad run for a long time because interest rates were low. They just haven’t carried their weight and that’s pretty atypical,” he says. “But at the same time, it will be atypical for this trend to continue over the next 10- to 12-year cycle.”
If his clients already owned some bonds, they were generally higher quality credit bonds, held for a shorter duration. Mr. Feindel notes that short- and mid-term bonds now yield in the 5 to 6-per-cent range, while some long-term corporate bonds yield around 9 per cent, albeit with more higher risk.
“You want to lock into bonds when the interest rate is high,” he says, noting that when interest rates go down, the prices of bonds increase and thus they yield less. For example, a client who purchased a bond yielding 5.6 per cent today would pay more for that same bond two years later if interest rates are lower. The new bonds, by comparison, would be issued at lower rates of return.
How a recession could impact credit risk
Mr. Feindel no longer sees inflation and interest rates as the biggest threat to bond performance. In his view, the big question is whether Canada goes into a recession and, if so, how severe.
“If you believe we’re headed for a recession, you probably don’t want to be in the high-yield space,” he says.
“While high yield means it’s paying higher, it also comes with a higher risk of default. If we head into a recession, then some lower-grade bonds may default. But longer duration investment grade bonds do well in a recession.”
Making the case for bonds can be difficult when products such as guaranteed investment certificates (GICs) and high-interest savings accounts (HISAs) have been paying upward of 5 per cent. Mr. Feindel notes that tax consequences of GICs and HISAs need to be considered in the decision-making equation as any interest earned is fully taxable. In comparison, a bond rate of return is partially capital gains taxed at 50 per cent, and the coupon is taxed as interest.
The other question is how long GICs and HISAs will continue to offer attractive rates of return.
Mr. Vo-Dignard says he finds 5 per cent is the psychological threshold for clients who want to preserve their assets. Clients need to understand what they’re buying and the type of bond.
“They have to watch for credit risk and what sector they’re buying,” he says. “People tend to see bonds as guaranteed, but it depends on the issuer.”
He isn’t considering long-term bonds at this point, and neither is Mr. Waller. While there’s potential for larger capital gains, Mr. Waller notes that “we have no idea what’s going to happen in the business environment in 20 years.”
He admits his client portfolios are still carrying quite a bit of cash, for which clients are getting paid handsomely. He prefers bond exchange-traded funds over individual bonds, ultimately wanting to “get clients to the finish line with the least amount of risk.”
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