Investment strategy for the current market conditions
Another nail went into the fixed income coffin this week after two of the world’s largest sovereign wealth funds cautioned investors to expect much lower returns in the current interest rate environment.
Singapore’s GIC Pte and Australia’s Future Fund announced the typical balanced portfolio of 60 per cent stocks and 40 per cent bonds no longer works, as even the tamest inflation threatens to put real returns into negative territory, with little hope of significant increases for the foreseeable future.
It’s part of a trend out of bonds among pension funds ranging from individual company pension plans to the Canada Pension Plan (CPP), where managers either need to boost risk on the equity side to maintain returns or take their lumps in the security of fixed income.
Interest rates have been near rock bottom since the global financial meltdown of 2008 but the prospect of fluctuating rates, even in a narrow range, have allowed big institutional investors to generate gains by trading bonds with fixed rates in mid maturity. Now, with yields having nowhere to go but up, a 40-year bond rally that generated returns between six per cent and eight per cent appears to have gone flat.
Sue Brake, chief investment officer of Australia’s US$168.4-billion fund told Bloomberg that “replacing it (bond yields) is impossible -- I don’t think there’s any one asset class that could replace it.”
The yield drought for small retail investors without the means or expertise to trade on global bond markets, however, has already been taking place for 12 years.
The stakes are much higher for regular folks who need reliable cash streams to live in retirement. Investment advisors who recognize the need for a better balance between growth and safety have long abandoned the 60/40 split and ventured into riskier dividend-paying equities such as blue-chip stocks and real estate investment trusts (REITs). Some have attempted to maintain a significant fixed income weighting with bond funds but the fact that the bonds they hold are often not held to maturity means returns are sporadic, and are not likely to produce the needed income with interest rates stuck in the mud. All of these fixed income proxies are really not fixed income because the income they produce is not fixed.
Fixed means guaranteed and, unfortunately for savers, that means government bonds or guaranteed investment certificates (GICs). Normally, investors can squeeze out extra yield through longer-term bonds but the tiny difference is not worth the risk of being stuck in a bond for a longer period of time as inflation eats away at returns. The formal term for a small or no-yield variation among bond maturities is a flat yield curve. As an example, the yield on a one-year Government of Canada bond is just under 0.3 per cent while the ten-year yield is well below two per cent.
That leaves investors saving for retirement with a stark choice: take on more risk or increase safety by lowering return expectations. For those choosing safety, the current yield on a one-year GIC can be as high as 1.5 per cent; slightly higher than the growing rate of inflation. It’s not much but it is better than zero from cash.
There’s another option for homeowners near or in retirement who want to use prolonged low interest rates to their advantage. They can shoot for higher returns by maintaining a larger equity weighting in their portfolios and tempering the risk with a home equity line of credit (HELOC) when needed.
If equity markets are in a slump when short-term cash is needed, borrowing from the equity in your home can cost less than three per cent and be paid back when markets recover.
But using borrowed money to balance portfolio risk can be tricky for some. It might be wise to first speak with a qualified financial advisor.