Fixed income: Safe and sound

My dad worked in a factory, and I grew up in a normal family—I don’t think I’m smarter than anybody else. But I happened to be in the right thing at the right time. A partner and I started an automotive parts manufacturing company and it went way beyond what we ever dreamed. When we sold it I was able to retire at 50. Suddenly I had a pile of money and I didn’t know what the heck to do.

Over the years I had bought and sold a bit of stocks: some good ones, but mostly not good ones, so I wasn’t eager to put money into stocks. I talked to my dad, and he had his money invested in GICs. So I went to see the same guy he used, and I bought a whole whack of GIC rates: this was the late 1980s, and I got 15.5% for five years! I staggered them the same way you would ladder bonds so I could draw a regular income. But when the five years was up, I thought, now what will I do?

Eventually I connected with Alan Tchabushnig, an adviser who told me about bonds. He helped me build a ladder of government bonds going out as much as 15 years. I got a good income from them, and when interest rates went down we sold some at a profit. Then the yields started to drop, so we switched to corporates. We have them all laddered, so if things change drastically we’ll have time to make adjustments.

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Maybe you used to be an equity investor, but you got pummelled and now you’d sooner slide down a cheese grater than buy another stock. Or perhaps you’re a diligent saver who has amassed a comfortable nest egg, and you can get by just fine with risk-free returns of less than 5%. Whatever your profile, you can fund a comfortable retirement without investing in stocks. But you’ll likely have to get away from savings accounts, money market funds and Canada Savings Bonds—those dreary investments can’t even keep up with inflation. Here’s how you can succeed with a super-safe all-fixed-income portfolio:

Get the most from your GICs. There’s a place for GICs, but not if you accept the terrible rates offered by the Big Five banks. At press time, their one-year GICs were offering just a 0.75% annual return, compared with much better rates from the online banks: 1.75% from ING Direct and 2% from Ally. You can also enlist the help of a deposit broker, an independent dealer who will shop around at banks, credit unions and other financial institutions to get you the best deal.

Build a bond ladder. One of the biggest knocks against GICs is that they usually have terms of five years or less. “Anyone who hasn’t invested in fixed-income securities longer than five years has been a loser over time,” says Hank Cunningham, fixed-income strategist at Odlum Brown in Toronto, and the author of In Your Best Interest: The Ultimate Guide to the Canadian Bond Market. Since the late 1990s, 10-year Government of Canada bonds have yielded about 1% more than five-year GICs on average. “That’s a lot of compounding left on the table.”

Cunningham’s preferred strategy for fixed-income investors is to build a 10-year bond ladder: you invest 10% of your money in a bond that matures in one year, another 10% in a two-year bond, and so on up to 10 years. Every year one of the bonds will mature, and you reinvest it in another 10-year bond. This strategy smooths out your returns and risks over the long term. “You’re not guessing about interest rates,” Cunningham says.

“You’re buying the best yielding product you can, and yet you won’t get caught with the wrong maturities at the wrong time.” In a taxable account, he suggests using provincial or investment-grade corporate bonds for each rung, since Government of Canada bonds have lower yields. In an RRSP, investors can also use strip bonds.

Use low-fee bond funds or ETFs. Many bond mutual funds in Canada are too expensive— they’re almost guaranteed to trail their index benchmarks. The median MER of a Canadian bond fund is about 1.5%, and while that’s lower than most equity funds, bonds offer fewer opportunities for active managers to add value. “These guys are guessing with your money, because nobody knows where the bond market is going,” says Cunningham. He also dislikes the fact that bond funds never mature, and their annual returns fluctuate with the market, which makes retirement planning difficult.

That said, if you seek out the lowest-fee options, bond mutual funds and exchange-traded funds (ETFs) can be attractive to fixed-income investors (see some suggestions above in Best fixed-income funds). In addition to simplicity and liquidity, they offer instant diversification, and they’re open to investors with portfolios of any size.

How have bonds performed? Amazingly well, over the period we looked at. As you can see in Steady as she goes above, the DEX Universe Bond Index, which includes Canadian government and corporate bonds, had just two negative years in the last three decades (1994 and 1999), while averaging returns of about 9.9% a year. However, it should be noted that this was over a period of steadily declining interest rates—an ideal environment for bonds. Rates are now at historical lows, so a repeat performance is unlikely.

What can go wrong? The price of security is lower returns—if you’re not prepared to accept that, you shouldn’t be a fixed-income investor. “In a low-inflation world, 4% to 6% is what you should expect to get from a bond portfolio,” Cunningham says. The surest way for GIC and bond buyers to blow themselves up is to reach for more.

Junk bonds spinning off yields of more than 8% are very tempting these days, but there is no reward without risk: the default rate on U.S. high-yield bonds was almost 14% in 2009. Cunningham says a high-yield bond ETF may be appropriate for 10% of a portfolio, but proceed with caution. “Fixed-income is supposed to be about peace of mind and safety of principal.”

Best fixed-income funds

If you’re building a fixed-income portfolio with mutual funds, keeping costs down is paramount. These low-fee funds hold high-quality corporate and government bonds and have excellent track records.

Exchange-traded funds (ETFs), which are bought and sold like stocks, offer even lower costs. They also give you the option of using specialized funds to build a custom fixed-income portofolio.