The article “New Investment Approaches For Risk-Averse Canadians” was originally published on MoneySense on April 28, 2021.
Old-school investors may find the capital preservation techniques they have relied on in the past won’t work the same in the future.
Bonds have long been the solution for investors seeking capital preservation and reducing portfolio volatility. But falling interest rates have made it tough to earn a fixed income return while preserving capital.
The result is that many fixed income investors are paying fees that are comparable to the expected return from an investment grade bond, implying basically no net return after fees (let alone after tax and inflation).
Interestingly, the aforementioned bond index returned 8.68% in 2020—and not many people in the investment community, nor bond investors themselves, would have expected an almost double-digit bond return last year. So, what was the reason for that surprise? Bonds and interest rates move in opposite directions, and interest rates fell due to the pandemic.
In much the same way bonds rose in 2020 as interest rates fell, if interest rates rise, bonds will fall. The Bank of Canada made an interest rate announcement on April 21, and as expected, kept interest rates steady. However, they have accelerated their timeline for inflation returning to their 2% target to the second half of 2022, meaning interest rate increases could come as early as next year if growth continues to heat up.
As interest rates rise, bonds fall. In fact, if interest rates rose by 1%, Canadian bonds – as measured by the FTSE Canada Universe Bond Index—would drop by about 8%.
So, what is a bond investor to do? Paying 1% to 2% to earn 1% to 2%, while taking on interest rate risk, is chancy. Guaranteed investment certificates (GICs) from credit unions or trust companies may provide higher returns for really conservative fixed-income investors. Higher-yielding, lower-credit quality bonds with higher coupon payments and shorter maturities may provide better returns in a rising-rate environment.
There are alternative investments, like real estate and infrastructure, but these tend to have higher fees and poor liquidity, and may be difficult for retail investors to access. These are all riskier investments than investment-grade bonds and may not provide the same benefits.
Bonds are not just meant for return. They are also meant for reducing volatility as stocks go up and down, so in that regard, should not be excluded from a portfolio for a conservative or moderate risk investor simply because interest rates are low.
