What sky-high bond prices mean for your yields

The price of Canadian government bonds shot up to unusual highs this week as the stock market tumbled. As a result, yields shrivelled.

The yield on 10-year Canadian federal government bonds fell to 1.04%. At the short end of the curve, 1-year Canadian treasury bills provided yields near 0.41%.  In between, 5-year bonds generated yields of about 0.51% and 7-year bonds 0.83%. (All based on data from Bloomberg and the Bank of Canada.)

Overall, federal government bonds don’t provide much in the way of income these days and that doesn’t factor in inflation, fees, and taxes.

Inflation is the propensity for money to lose purchasing power over time. The latest inflation reading came in at 1.6%, on a year-over-year basis, in December. As a result, inflation currently eats up more than the 1.0% yield offered by 10-year bonds. Should inflation persist at similar levels, bond buyers will lose purchasing power over the next decade.

Add an annual fund fee–that might range between, say, 0.3% for an exchange traded fund and 2.0% for a mutual fund–for further misery. Even a small 0.3% fee eats up almost 30% of the 10-year yield and more than 70% of the 1-year yield. The 2% fee would result in big losses.

It should come as no surprise that the low rate environment has prompted many bond fund managers to move into riskier higher-yield offerings. That might mean loading up on longer-term bonds, those with credit risks, or a combination of the two. As a result, a seemingly safe bond fund might actually contain a steaming pile of risk.

Taxes add to the joy because interest is–in most cases–fully taxable. Individuals in high tax brackets might see about half their interest gobbled up by the tax man.

But look on the bright side, it could be worse. After all, the Bank of Canada recently mused about pushing its benchmark short-term rate into negative territory.

If you really want to sweat, take a trip overseas; 10-year government bonds yield -0.02% in Japan. The rate on similar bonds in Switzerland is a distressingly low -0.35%.

We live in interesting times.

 Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of February 8. The list is a good starting point for those who want to put some money to work this week. Just keep in mind, the idea is to hold the stocks for at least a year after purchase – barring some calamity.

Source: Bloomberg, February 8, 2016

Notes

Price: Closing price per share

P/B: Price to Book Value Ratio

P/E: Price to Earnings Ratio

Earnings Yield: Earnings divided by Price, expressed as a percentage

Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently. Remember, stocks can be risky. So, be careful out there. (Norm may own shares of some, or all, of the stocks mentioned here.)

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