Sell equities, buy corporate bonds for high returns: Earl Davis
2023 marks the year that the humble guaranteed investment certificate (GIC) became a superstar.
A series of interest rate hikes by the Bank of Canada starting in early 2022 has propelled GIC yields from below one per cent to as high as 5.75 per cent.
For Canadians investing for retirement, the advent of higher fixed-income payouts brings a safer way to compound returns over time. A five per cent annual return over 30 years, for example, adds up to $348,800 – nearly $200,000 of it as interest alone.
The rise in fixed-income yields also rekindles a long-term portfolio strategy that adds a fresh element of safety without sacrificing growth.
RETURN OF THE 60/40 SPLIT
Fixed-income rates have been in the doldrums for nearly three decades, but older investors might remember double-digit yields in the late twentieth century.
At the time, one basic portfolio strategy to balance the safety of fixed income with the growth potential and volatility of equities was the 60/40 split – roughly 60 per cent of assets in a portfolio would be allocated in equities and 40 per cent in fixed income.
Another twentieth century benchmark for splitting equities and fixed income allocates a fixed-income portfolio weighting roughly equal to the age of the investor. That means a 50 year-old would have half of their portfolio in fixed-income to achieve a similar balance between safety and growth.
The exact split would be based on individual circumstances, mostly risk tolerance and time horizon, or length of time to retirement. Increasing the fixed income portion over time makes investment returns more reliable as the investor heads into retirement and income is essential to meet day-to-day living expenses.
HOW FIXED-INCOME BECAME BROKEN
As interest rates and yields plunged at the start of the twenty-first century, retirement investors turned to less reliable sources of income for their fixed-income fix such as dividends from equities or real estate investment trusts (REITs).
While yields were much higher than fixed income at the time, investors always ran the risk that the underlying equity would fall in value with the broader market or the issuer would arbitrarily reduce the dividend.
Bond funds, which trade fixed-income securities on the bond market based on interest rate speculation, also became portfolio staples as a replacement for fixed income.
All that changed in 2023 as real fixed-income yields surpassed equity yields.
GICs and investment-grade government and corporate bonds are considered fixed income because their yields are fixed to maturity. In other words, you know what you’re getting and when.
While the risk of default is always present with corporate bonds, GICs are permitted to use the term “guaranteed” because they are ultimately backed by the government of Canada.
HEDGING AGAINST INFLATION
The only risk associated with most fixed income is inflation eating away at yields. A five-per-cent return doesn’t add up to much in the real world if inflation is running at three per cent, for example.
This week the Bank of Canada held its benchmark interest rate at five per cent, stating that previous increases have successfully tamed inflation, but that could change.
Within a fixed-income portfolio, there are long-term strategies to hedge against inflation and maximize returns by staggering maturities over time to take advantage of the best going yields as often as possible.
The most common strategy, known as laddering, targets regular paydays for retirees who need the cash.
There is no single set of rules when it comes to managing a fixed-income portfolio for individuals. The portion of fixed income in the overall portfolio, the total duration of a ladder and the types of fixed income investments depend on when and how the investor wants to retire.
That’s something a qualified investment advisor can help with.