To diversify your investments you should have a fixed-income component in your portfolio, such as guaranteed investment certificates or bonds.
But you should have an understanding of the different ways of holding fixed income investments and the underlying risk of each option.
Term deposits and guaranteed investment certificates are a common way to hold fixed income. The return is known and all fees are built into the initial sell price. If you purchase a one-year $100,000 GIC at 4.5 per cent then you can count on receiving $4,500 and your original capital back in one year. This certainty comforts a lot of people and the investment is easy to understand. It is also easy to plan your cash flows.
Holding federal and provincial government bonds are generally considered low risk. In recent years, GIC returns have often exceeded the returns offered by low risk government bonds. Investment grade corporate bonds can be another way to purchase fixed income. The return potential on corporate bonds generally exceeds government bonds and GICs but the risk element increases.
Another common form of fixed income investment is a bond mutual fund or a balanced mutual fund. A bond mutual fund invests in a basket of fixed income investments. Depending on the fund prospectus, the mandate can result in significantly different structures between funds. Not all bond funds are created equal. Some bond funds are very conservative while others may take on considerable risk.
Conservative bond funds may hold government bonds and investment grade (BBB rating or better) corporate bonds. Treasury bills, banker’s acceptances, and term deposits are all considered low risk and are common in conservative bond funds. One of the benefits of holding bond funds is the ability to diversify your fixed income. Diversification of fixed income can be done through holding different types (issuers), qualities (credit ratings), and maturities (mixture of short, medium, and long term).
The added “diversification” benefit of bond funds comes at a cost often referred to as a management expense ratio (MER). Regardless of where interest rates are at, it is important to ensure you are not paying an excessive amount to manage your money.
As an example, let’s use a typical bond fund with an MER of 1.5 per cent. Let’s also assume that GIC rates are currently 4.5 per cent. Individuals choosing the bond fund option should feel comfortable that the manager can put at least 4.5 per cent in your pocket. With an MER of 1.5 per cent, the manager of this bond fund will have to take on some risk to earn 6.0 per cent or more. Your return is not guaranteed with bond funds and can be negative.
Riskier bond funds do exist and have very different mandates than the typical conservative bond fund. Bond funds that hold non-investment grade bonds, also known as high-yield or junk bonds, may certainly have the potential to earn 6.0 per cent or more. They also have a much higher degree of risk and generally have a higher MER. Other funds may hold foreign bonds or concentrate in certain countries such as the United States.
We caution investors to understand currency risk before investing in foreign bonds. For investors with a large portfolio, foreign bonds may provide some additional diversification. Some bond funds have a small equity component, generally with dividend paying investments such as common shares. If a fund holds a significant equity component then it is often referred to as a balanced mutual fund (holding a balance of equities and fixed income).
We encourage most investors to keep things simple. Establish an asset mix and determine the percentage of fixed income that is suitable for your individual risk tolerance. Once the fixed income component is established we recommend most investors stick to lower risk and investment grade options.