Sometimes I wonder, why bother? Sigh.

Late last week this pathetic blog offered a guide on how to build the fixed-income (safe stuff) portion of a balanced portfolio. The advice was simple. Own some bonds to reduce volatility and counterweight inevitable plops on the growth side. Mix the bonds up between federal, provincial corporate, high-yield and real return (if you have enough dough). And embrace preferreds, with their 5% tax-reduced yield and potential for capital gains as rates eventually rise.

Experience has shown me that people think (a) investment-grade bonds are like savings bonds (you buy the thing, hold it to maturity then cash it in); (b) when interest rates move up or down bond yields change along with them; (c) bonds don’t give capital gains, only interest; (d) you only buy preferreds because, like stocks, they might rise in value: and (e) all bond values drop when rates rise.

Actually, not quite true. The majority of people, I betcha, have no idea what a bond is. Or a preferred. Or where to buy some. Those who do (think they) know something about investment assets delight in further poisoning the knowledge pool of the innocent by coming here to dis my words. So, last week the stock-pickin’ cowboys, bullion-lickers and GIC braindeadheads piled on to spread misinformation. I could correct the little peckers, but there’s no real point. They won’t change.

Bonds are debt obligations so when you buy some you’re handing over money to a government, utility or corporation in return for regular interest. But with rates in the ditch, it makes no sense to collect interest, which is fully taxed anyway. Bonds also have prices, so while the yield a bond pays you never changes, the value of the bond does. Prices rise when rates fall and vice versa. So as rates move higher in the future, bonds are worth less. The ‘longer’ until the bond matures, the more its price falls. So bonds with ‘short duration’ (closer to maturity) are safer in these times.

However, bond prices are also dictated by demand. When stocks are scary, money flows into bonds seeking safety, and the price of the bonds pops higher. So when equities tank for a while (like after Brexit), bond prices inflate. If you hold exposure to both in a balanced portfolio, one move helps cancel the other so overall volatility is sharply reduced. With less volatility you’re not so inclined to run around screaming, sweating profusely, scaring animals and pounding your keyboard with ‘sell’ orders.

So there’s a role for bonds. Government ones are the safest (federal or provincial), followed by utilities and investment-grade corporate bonds. Also have some managed high-yield debt (sometimes called ‘junk bonds’) in the portfolio – money owed by less creditworthy debtors (like Air Canada or Ford Credit – hardly big risks) who are willing to pay several times the interest. And real-return bonds increase their effective yield every time inflation spurts, and are government-backed.

As for preferreds paying more than 5%, sending cash into your portfolio every 90 days and offering a dividend tax credit at the end of the year, why would you not want to own some? Sure, the value of rate-reset preferreds declines when interest rates are cut, but I think we all know this is the bottom (or close to it) of the interest rate cycle. While prefs paid a juicy return last year, their capital values were whacked when the Bank of Canada chopped rates twice.

So now you have the best of both worlds – a far bigger yield than a GIC produces (without locking up your money) plus the potential of capital gains as rates inexorably creep higher over the years to come. Together with the bonds, the fixed-income part of your portfolio should be delivering a 4% return – twice that of any GIC, with 100% liquidity and less taxation (plus reduced volatility and the potential for capital gains).

The way to do this? Through ETFs, not via individual bond purchases or by buying the preferreds of any one company. When you do, pay attention to the duration of bonds, and the kind of the prefs in the exchange-traded funds, as well as the embedded fees and the liquidity. Ensure the bond debt lives inside an RRSP so interest is sheltered, and the prefs go to your non-registered account, generating the tax credit. Then rebalance as required by markets and events. If all that’s too damn much work, hire an advisor.

Here’s Kyle with a good question (after the obligatory suck-up):

“I have not missed a blog post for nearly 3 years which is a testament to my outlandish lifestyle. I am a millennial (27yo) and own 2 dogs, a golden retriever named Harvey and a lab/retriever mix named Dexter. They are also big fans and get up early with me to look at the pictures you include in your posts.

“Where I get lost is asset allocation. Assume a $300k portfolio spread over registered/unreg accounts, maxed out TFSA’s, wiggle room left with RSP’s and about $140k unregistered. All your loyal readers are aware of basic allocation strategies, 60/40, rule of 90, keeping interest bearing investments (lol) in registered accounts etc. Where I get lost and other novices I am sure, is how to allocate based on the type of the account. For example, is a 60/40 split referring to the entire portfolio or each individual account? Obviously growth stuff in a TFSA makes sense but to prevent myself from rambling, I think it would be a good idea for a post as it nicely compliments the main narrative of your blog. A response would be awesome.”

That’s easy. The 60/40 portfolio mix should apply to your entire portfolio – the cash account (always make it joint with your squeeze), RRSPs, tax-free accounts, plus any LIRAs from previous jobs or RESPs for the kids (never put GICs in there). The point is to ensure a holistic approach to your finances – to blend performance with tax avoidance, and ensure your finances are overall balanced, diversified and liquid. Don’t segregate pots of money – such as for retirement, house money or escort services – since volatility will swell and you’ll end up screaming and sweating.

Reading this blog has essentially the same effect, of course. But you came here.

Have we lost our way?

RYAN  By Guest Blogger Ryan Lewenza

What happened to us? We Canadians used to be a practical lot where we lived within our means, and prudently managed our financial affairs. Gone are the days of “starter homes” or waiting to purchase something until we actually had the cash on hand. How novel! Now, we all want that “starter home” to be decked out in granite countertops and stainless steel appliances. Keeping up with the Jones (or is it the Kardashians?) has never been so pervasive!

Last week we heard from Statistics Canada that household debt rose to a new record high of $1,973 billion, driven by, no surprise, an increase in mortgage debt. More importantly, growth in debt outstripped income growth once again, helping to push household debt to disposable income to a new record high of 170.5%.

In comparison, the US household debt to income ratio has declined considerably since the financial crisis, to 138% currently. Think about that for a moment. We now have significantly higher debt to income levels than our more profligate friends south of the border, and have the highest debt to income ratios of any G7 nation. Yikes!

This rate of debt accumulation is simply not healthy nor sustainable. With Canadian debt levels at record highs, and interest rates at record lows, it doesn’t take a genius to put two and two together, and see the risk this poses.

Now one of the upsides of record low interest rates is that with credit so cheap, it has helped drive the debt service ratio lower, despite our record amount of debt. The debt service ratio measures total debt obligations (interest and principal) as a percentage of disposable income, and it remains at a reasonable level of 14%. That’s off the 2007 highs of 15% and is below the US currently at 15.3%. The question then is, what happens when interest rates ultimately rise, driving up debt servicing costs. While the Bank of Canada has intimated that rates will stay lower for longer given our lackluster economic growth, it is not whether they will hike rates in the future, but rather when and by how much.

Add in the fact that according to the BMO Rainy Day Survey, that one quarter of Canadians live paycheque to paycheque with little to no funds set aside for an emergency and that 44% of Canadians have less than $5,000 in emergency savings. This doesn’t leave much room for error, once interest rates start rising.


Source: Bloomberg, Turner Investments

It’s not all bad news, and I think it’s important to take a balanced view when looking at Canadian household wealth. Often we focus on the income side and overlook the asset side of the equation. On that front, Canadian household debt to assets continues to trend lower, from a peak of 19.3% in Q1/09 to 16.7% currently. Our national wealth rose by 2% in Q2 to $9.8 trillion, in large part driven by higher home values. On a per capita basis we sit at $271,000, coming in at 11th spot among 35 OECD developed nations.

There’s good debt and bad debt, and debt used to purchase assets like a home or dividend paying stocks is always preferable to debt used for consumption. At least you have something of value against the debt, rather than a bad hangover and an empty wallet after an expensive bender in Vegas. This is just what I’ve heard of course about Vegas.

On the surface the declining debt to assets ratio is encouraging. However, what happens if the assets (i.e., Canadian home values) deflate, as is our expectation? Well, then we’re stuck with a high debt load and a depreciating asset, never a good combination.

To be clear, we remain long-term bulls on the Canadian economy given our abundance of resources, our solid fiscal shape and strong rule of law. But we see all this debt one day catching up to us and there being consequences to our current reckless and ostentatious behavior.

Now I have to get back to my ebay auctions as there is a Rolex and Canali suit with my name all over it. Wish me luck!


Source: Bloomberg, Turner Investments
Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.