Thursday, September 20, 2012

Rule #19 No Fixed Income.

When the topic of portfolio asset allocation comes up in discussion with financial folks, they will often talk about the ratio of equities (stocks) to fixed income (bonds).  Some advisors recommend a 60/40 ratio adjusted either up or down depending on your age and risk tolerance.  They often use bonds as a type of a hedge against big drops in the market.  If stock values drop, bonds tend not to drop the same amount under the same market conditions.  The opposite is also true in that bonds tend not to rise anywhere near as much as stocks do during bull markets.  Once you take the market value gains or losses out of the picture as we do, are fixed income investments a good fit for our model? Not the way we look it.

We have no fixed income in our investment portfolio and we won't be adding any anytime soon.  Fixed income is defined by as: A security that pays a specific interest rate, such as a bond, money market instrument, or preferred stock. This sounds pretty good on paper. Its essentially a near-guaranteed return on your investment over a set amount of time.  A GIC (Guaranteed Income Certificate) is another form of fixed income with the word "Guaranteed" right in the name of the investment instrument. Wow! Guaranteed sounds pretty good, doesnt it?  

Because of the low interest rate environment in recent years, fixed income yields have been historically low.  GICs are currently paying about 1-3% annually depending on the term, and bonds are not paying much better.  These numbers are so low that they dont even keep up with inflation after considering both taxes and inflation.  Outside of Registered accounts, fixed income such as GICs and Bonds are taxed similarly to employment income so the tax rate can be as high as the 49% depending on what province you live in and what marginal tax bracket you occupy.  Corporate bonds pay better, and can be closer to 4-6% but most advisors would say that corporate bonds tend to be higher risk and if you are looking for safety, going to corporates are not the way to go.  They are also still taxed at potentially very high rates where up to half that higher rate is sent to government.  If you are looking at corporate bonds in general, you may have the appetite to go with either preferred or common shares that pay dividends instead.  

Canadian Preferred shares with dividends are the only types of fixed income that we would currently consider since the yields tend to be high and the dividend is taxed the same as Canadian eligible common share dividends which have a significantly lower tax rate.  Preferred shares tend to be a little more risky in their "secureness" compared to bonds, but if you screen your preferred shares with proper due diligence, they are a pretty safe alternative to bonds.

The main reason we do not invest in fixed income is because of the "fixed" nature of the gain and how your gain actually gets smaller over the term of the investment because of inflation.  The amount of gain you get as a percentage is the same at the end of the term as it is at the beginning.  If you buy a 10 year $1000 bond that pays 4% annually, 10 years later you are still getting 4% (pre-tax remember... in after tax dollars its much worse) on your $1000.  40 bucks per year at the beginning of the term and 40 bucks per year on year 10.  In the mean time, inflation is chugging along and all your money (both principle and income) has less and less buying power.  This means that in year 1 your gain might be able to buy a case of beer, but in year 10 will that same gain of $40 get you a case of your favourite ale? Probably not. 

It should come as no surprise that I prefer conservative Canadian dividend-paying stocks as a replacement of fixed income in our portfolio. A company stock with a healthy yield and a record of increasing its dividend at or above the rate of inflation would be a reasonable substitute in my mind with the potential for capital price growth to go along with the tax efficiency of the dividend.  An example of a stock like this would be Fortis. Fortis is in the electricity transmission business mainly in parts of Canada and the Caribbean.  People can't do without electricity, so its one of the safest industries to invest in and the need for energy transmission will continue to go up in the future so there is even the potential for modest growth.  Fortis currently has a dividend yield of about 3.6% and the company has a history of increasing its dividend, mostly at or above the rate of inflation.  Another great thing about Fortis is that with the increasing cash-flow comes an increase in the stock price as well.  As the cash-flow goes up, so too does the stock price.  Bonds do not have that kind of relationship as the yield never changes as you hold the investment.  To us, in comparison to bonds, the upside potential on a stock like Fortis well out-weighs the risk of keeping your money in this type of equity.  

(Full disclosure: I do not currently own any Fortis, but it is on my watchlist and would look to add some to our portfolio if the yield got to be over 4%.  I am not making any recommendation to either or buy or sell Fortis)


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