Bond funds are showing negative returns, and returns in recent years have been weak. What is the alternative?
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In an increasingly complex world, the Financial Post should be the first place you look for answers. Our FP Answers initiative puts readers in the driver’s seat: you submit questions and our reporters find answers not just for you, but for all of our readers. Today we’re answering a question from Don about investing.
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By Julie Cazzin, with Allan Norman
Q: What are the best options for cash in an investment portfolio now that bonds don’t work? — put on
PF responses: This is a good question because many bond funds are currently posting negative returns, and returns in recent years have been weak. What is the alternative? It depends on why you hold bonds in your portfolio and how comfortable you are with the alternatives.
An investment portfolio is a diverse mix of investments potentially serving different purposes such as growth, income and stability. Bonds are often included to provide income and/or stability.
If you need income from your portfolio – say $30,000 a year – you can put one to five years of income in a bond fund, or $30,000 to $150,000. A bond fund is used to earn income because it is less volatile than a stock fund. As you draw down on your bonds, you can replace them by selling some of your stocks when they produce positive returns.
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Conventional alternatives to bonds include high-interest savings accounts, guaranteed income certificates (GICs), and fractional preferred shares. If you need the money in a year or two, there’s nothing wrong with holding the money in a high-interest savings account. Of course, you won’t win much, but you won’t lose money and you can access it anytime.
GICs offer a guaranteed rate of return, but the challenge is that they are illiquid. They are immobilized, so you have to manage the due dates. Fractional preferred shares have generally provided higher returns than GICs or bonds in recent years. They are traded on an exchange and are normally issued with a unit value of $10/share and a maturity date.
Don, another option if your portfolio is large enough, generates enough dividends and distributions to supplement your income, and you don’t mind volatility, is to hold no bonds at all. In addition to the traditional alternatives to bonds mentioned above, there are non-traditional options.
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About four years ago I attended a conference with a presenter from a major bank and he asked a question similar to yours. “How are retirees going to earn enough in their portfolios to make their money last, but at the same time have a stable portfolio to provide them with income?”
His concern was that even though interest rates have fallen since 1982 and bonds have provided good returns, what if bond yields are low in the future? What if we get bond returns similar to those of the 40 years before 1982 and the portfolios don’t return enough?
Speaking of which, long-term US corporate bonds from 1942 to 1982 returned 2.82% before fees and inflation, but 10.1% from 1982 to 2021, according to Dimensional Fund Advisors Matrix Book.
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One option is to increase the equity component of your portfolio and reduce bond holdings, but this means increasing volatility risk and return sequence risk.
The proposed solution was to use alternative investments, such as private credit and private equity. These investments are not listed on the stock exchange. Part of his rationale was that pension funds use alternatives and they have the same problem as retirees, which is trying to maximize returns while providing income at the same time.
Speaking of which, the Canada Pension Plan currently only has about 40% of its money invested in traditional stock and bond investments. These alternatives include private credit (loans from a lender other than a bank), private equity (owning some or all of an unlisted security or a small company), and private equity. ‘immovable.
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All three have their own set of risks, but they are mostly only available through properly licensed advisers, and there are limits on the amount of alternative investments investors can buy. They are used in a portfolio to provide additional diversification to the traditional bond/equity allocation as well as increased flexibility.
For example, you can replace some of your bond holdings with private credit and some of your equity investments with private equity to reduce volatility and increase returns. The added benefit is that you also have four sources of income to earn rather than two – bonds and stocks. As you draw down your source of income (cash and bonds), you can replenish it from your private credit, private equity, or equity investments.
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Don, I’ve talked about alternatives to bonds, but bonds you own may be just fine. Remember that as interest rates rise, new, higher yielding bonds are purchased into the fund, and this higher rate is ultimately passed on to you. At some point, rates will fall again, perhaps in the next recession, and then you can see your bonds shine.
Allan Norman, M.Sc., CFP, CIM, RWM, provides certified fee-based financial planning services through Atlantis Financial Inc. Allan is also registered as an investment advisor with Aligned Capital Partners Inc. It can be attached to www.atlantisfinancial.ca or [email protected] This commentary is provided as a general source of information and is not intended to be personalized investment advice.
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