Searching for income

Most investors have a love hate relationship with bonds. On the one hand, they can lower the volatility of a portfolio and provide some safety; on the other the most popular fixed-income securities can offer little return. A five-year government bond, for example, currently yields 1.4%. With inflation at 1.3%, you’re basically getting nothing.

Still, people need bonds in their portfolio to balance out the ups and downs of equity markets. Fortunately, there is a way to get income out of fixed-income.

Jeremy Racicot, CFP and co-founder of The Bay West Group, is putting his clients’ fixed-income dollars into corporate bonds, or company debt, because they pay more than government bonds. “People are looking for yield so we’re scrambling to try and grow their money,” he says.

Corporate yields are an average of two percentage points higher than government bonds because there’s a higher risk of default. However, that risk is still low. How low? Standard and Poor’s put the U.S. corporate bond default rate at about 2.5% in March 2012. By 2013 the ratings agency expects that rate to climb slightly to 3.6%. Still, that’s below the long-term average of 4.5% and well below the 13.7% default rate in 2009.

The lower default rates are in part a reflection of the current strength of corporate balanced sheets. Since the recession, companies have cut costs and horded cash, which they can use to pay down debt and cover interest payments. Corporations have also benefitted in the past few years by investors looking for a safe haven for their money when equity markets got hammered. That surge in investor interest in corporate bonds made it easier for companies to refinance their debt and lower their borrowing costs

Mike Swan, an associate portfolio manager at Canso Investment Counsel, says that while the chance of default in a corporate bond is always present, investors might actually be taking a greater risk by buying government bonds. “Given the inflation risk, government bonds are a very risky place to be,” he says.

While the equity market is accessible to retail investors, the market for yield-hungry investors looking to buy a single bond is not. Bonds are typically sold in bulk to institutional buyers that have lot of cash and can use their size to negotiate a better price. That means the easiest way for retail investors to own fixed-income is either through a mutual fund or an exchange-traded fund.

Racicot says the best funds are the ones where the manager is free to move from government to corporate bonds. While most of the funds he buys for his clients are more heavily weighted to corporate debt, he’d rather leave it up to the fund manager to decide the bond mix. “I want them to be able to buy government bonds if they feel it’s warranted,” he says. “I don’t want to have to jump around between funds myself.”

Many of the funds he invests in also own short-duration bonds—fixed-income that matures in one to five years. In today’s economy, short-term bonds are preferred because they will take less of a hit if interest rates rise, says Swan. When rates climb, bond prices fall. If you own a 10-year bond, rates could rise multiple times over the life of the investment, pushing the security’s price down with each increase. A short-term bond wouldn’t have to deal with as many rate changes.

While investors can buy a fund with just short-term corporate bonds, but Swan suggests using floating rate corporate bonds as another option. These bonds are tied into inflation rates and not interest rates, which means that when rates rise the bond’s yield will rise with it. The downside is that if interest rates fall, and increase the value of the bond, a floating rate security won’t appreciate. But in today’s environment, rates are so low that they are more likely to increase then they are to fall. For that reason, says Swan, floating rate is the way to go.

If you do buy a bond fund, Racicot suggests keeping them in an RRSP or a TFSA. Bonds pay interest, which is taxed as income at your marginal rate. It’s better to defer the tax hit until you remove the funds from the account at retirement.

But there is an exception: corporate class bond funds don’t pay out distributions to unit holders, which means you won’t have to pay tax on the income. Racicot will use corporate class bonds outside of a registered account if his client’s RRSP is already maxed out for the year.

In this environment, where government bonds pay so little, Swan says it’s reasonable for someone to hold all their fixed-income in corporate bonds. But, because of the increased default risk, be sure you’re buying a fund that invests in solid companies. To do that, look at a fund’s track record over time. Pay close attention to how it did during the recession. “Don’t just look at the short-term period where all bonds have done well,” he says. “The fund should have a long track record and the manager should specialize in buying these bonds.”

As long as the default risk remains low and the yield stays high Racicot will continue buying corporate bonds for his clients. “Some of these funds have done very well in the last five years,” he says. “So I’ll keep seeking out yield for my clients.”