The term fixed income can be confusing, especially when the financial industry has so many names for the same thing. For someone new to investing I typically draw a line down the middle of a page. On the left side of the page I label this “debt”, and on the right hand side I put “equity”. Debt is another term often associated with “fixed income”. In explaining what debt is I begin by using a simple example, a two year annual pay Guaranteed Investment Certificate (GIC). With a two year GIC you are giving your money to a company and in exchange you receive interest for the use of the capital. You receive your original capital back at the end of two years. You have no direct ownership in the company with debt.
The equity side of the page would have common shares, this is what most people would directly link to the stock exchange. Although some fixed income investments trade on a stock exchange, the majority of listed securities are equities. When the news is flashing details of the TSX/S&P Composite Index, the Dow, or the S&P 500 – these would all be equity indices reflected on the equity side.
Most people would agree that on the equity side of the page it would not be a good idea to put all your eggs in one basket. A prudent approach would be to diversify your equities by holdings various different stocks (i.e. between 20 and 30 different companies) in different sectors and geographies.
All too often I come across investment portfolios that have zero diversification on the fixed income side. As an example, it may be a person that has $500,000 or a million dollars all in GICs. In my opinion the best approach to fixed income is to have diversification – different types and different durations.
If we move back to the left hand side of the piece of paper, underneath debt we have already listed GICs. Let’s list a few other types of fixed income investments including: corporate bonds, government bonds, real return bonds, bond exchange traded funds, notes, coupons, preferred shares, debentures, bond mutual funds, etc.. Over the last decade there has been a huge growth in non-domestic bonds for retail investors. Perhaps one area that is often underutilized by many Canadians is the use of international bonds. Bonds are available in different developed countries. Advisors are able to purchase direct foreign bonds in developed countries and emerging markets. The emerging market bond space has opened up many different opportunities. With certain structured bond investments, these can be hedged to the Canadian dollar or not hedged (you are exposed to the currency risk).
Within each of the above main categories there are sub-categories. As an example, with bond ETFs one could purchase numerous different types, including: floating rate, short duration (example: one to five years), long duration, all corporate, all government, high yield, US bonds, etc.
Another example of subcategories can be explained using preferred shares as an example. Preferred Shares are generally classified as “fixed income” even though they pay dividend income (similar to common shares that are on the equity side of the page). For clients who have non-registered funds, a portion of your fixed income in preferred shares can be more tax efficient than interest paying investments. The main types of preferred shares are retractable, fixed-reset, floating rate, perpetual, and split. All have unique features that an advisor can explain to you.
When equity markets perform well it is natural that they become overweight in a portfolio. We encourage clients to periodically rebalance to their preferred asset mix. In good equity markets this involves selling some of the growth in equities and purchasing fixed income investments. When equity markets are declining, the process of rebalancing could result in selling fixed income and purchasing equities at lower levels.
The idea of adding “fixed income” is not that exciting in this low interest rate environment, especially when many “equity” investments have yields that exceed investment grade short duration bonds. Opportunities still exist in fixed income for reasonable yields, especially when you explore different types of fixed income. One always has to assess the risks they are comfortable with. As an example, I ask clients what they feel is the greater risk, stock market risk or interest rate risk. By stock market risk, I define this as the risk that the equity markets will have a correction or pull back (say, 10% or greater). By interest rate risk, I mean that interest rates will jump up materially and do so quickly (in a short period of time).
Every model portfolio I manage has fixed income. This is the capital preservation and income side to a portfolio. The percentage in fixed income really comes down to a clients risk tolerance and investment objectives. Time horizon and the ability to save additional capital is also a key component in determining the allocation to fixed income. It is important to first determine the right amount to allocate to fixed income, and second, to diversify it to enhance liquidity and overall returns.
Kevin Greenard CA FMA CFP CIM is a Portfolio Manager with The Greenard Group at ScotiaMcLeod in Victoria. His column appears every second week in the TC. Call 250-389-2138.