March 18, 2007

Investing in bonds
Risk, tax status influence selection

In my last instalment, I wrote about the importance of bonds in overall portfolio strategy. I noted that bonds are not bought for high-return potential but for their dual roles as diversifiers and stabilizers. If you're sold on the idea of holding bonds, even in this low-rate environment, the next step is figuring out what kind of bond exposure to obtain and which investments to fill the role. Both of these decisions are likely to be driven by risk tolerance and tax status.

Risk tolerance

Aggressive investors may be comfortable with holding longer-dated bonds (i.e. taking on greater interest rate risk) or those sporting a sub-investment-grade credit rating (i.e. taking on greater credit risk) in an effort to reach for yields. Conservative investors may not be so willing to assume this same level of risk in their bond components. Today's bond market brings good news for conservative investors but not-so-good news for aggressive bond investors.

Conservative investors will be happy to know that, at 3.9%, a nine-year Gov't of Canada bond yields just 30 basis points more than short-term treasury bills. Taking slightly more credit risk by investing in provincial bonds can add 20-40 basis points annually in extra yield today.

(The sources of all bond yield data are TD Waterhouse Discount Brokerage and the Bank of Canada website, accessed today).

Still higher yields can be obtained by going to corporate and high yield market, but the 'spread' above government bonds is lean by historical standards and just a fraction of the spreads of late 2002 (when we strongly recommended overweighting corporate and high yield bonds).

Conservative investors may find comfort in short-term, high (credit) quality bonds since the give-up in yield (compared to riskier bonds) is not significant. If sticking to government bonds, buying a bond directly is a good strategy as long as it is held to maturity. However, low fee funds are worth considering given their built-in ability to reinvest interest. Beware, however, as sub-4% yields are quickly gobbled up by fund fees. Financial advisors may be better simply using high interest cash accounts to give their clients competitive yields while still making a bit money for themselves.

Should aggressive investors gravitate toward high yield bonds, this should be done cautiously given my valuation concern above and the apparent economic slowing. I continue to include high yield exposure in portfolios I oversee (albeit not as enthusiastically as in late 2002), but only in the context of well-diversified bond components. Fees remain important here also. Firms offering the lowest cost corporate or high yield options include: Barclays (iShares), PH&N, Standard Life, Trimark, TD, Renaissance, and GGOF. Fees much above 2%, however, risk eating up the higher yields offered on these portfolios. Securities-licensed advisors are at an advantage here since they can build in a typical 0.4% annual compensation on bonds while keeping total fees on this component below 1% annually.

Also, neither investors nor advisors should try their hand at picking high yield bonds, unless they happen to have a specialty in this area. Instead, treat them like stocks and diversify to reduce risk through the use of a fund.

Tax status

For investors holding a significant amount of their investments outside of tax-deferred retirement accounts (i.e. RRSP, RRIF), including bonds or other fixed income in their portfolios is difficult. This is because of the ultra-low yields offered by bonds on an after-tax basis. Take the above yield of about 4% on mid-term bonds. After paying taxes, such bonds leave just 2% to 2.5% in your jeans.

This is low enough to repel investors from bonds entirely. However, there are options to soften the tax blow and keep a respectable amount of the yield after-taxes.

Increased demand for income and last year's introduction of trust taxation have turned many heads toward preferred shares. Like bonds, so-called 'preferreds' are available in both investment grade and sub-investment grade credit quality. While they are generally a bit riskier than bonds, they also offer after-tax yields that are well ahead of bonds.

But investing directly in preferreds is not advisable because of the wide variety of provisions that affect valuation; and the thin liquidity, which requires a great deal of patience. Mutual funds that focus on preferreds are a thing of the past as fund companies prefer to gather more assets than restrict size to invest in preferreds.

The best options today are pooled funds and closed end funds. With pools the big issues are access (i.e. must be an accredited investor), portfolio management quality, and fees (usually low for pools). With closed end funds, a unique issue will be to clarify the extent to which leverage is used since this not only affects potential fees but also the portfolio's true interest rate sensitivity.

On the other hand, corporate class mutual funds or other funds using derivatives (for tax reasons) are plentiful today. The problem with corporate class bond funds is that fees are a bit steep (relative to yields), and one of the better offerings (from Bissett) is closed to new money - though CI has a decent offering. Key to deciding whether to use any of these products is estimating a net, after-tax yield based on current yields (not past total returns) in the context of a complete risk assessment.

Other considerations

It's important to keep the basic rule of asset location in mind - namely keeping highly taxed assets in tax-deferred accounts while focusing taxable money, if any, in more tax-friendly investments. Also, the above is targeted mainly to bond investments held in the context of a balanced portfolio. Where an investment instead has a very certain time horizon where safety is paramount; sticking to a high quality government bond with a term-to-maturity or duration that matches the time horizon may be the preferred option.