New investment approaches for risk-adverse Canadians

The current weighted average yield to maturity for the FTSE Canada Universe Bond Index is about 1.72%. According to Morningstar’s 2019 Global Investor Experience Study, the asset-weighted median expense ratio for Canadian fixed income mutual funds was about 1.49% for investors receiving commission-based advice. For investors in fee-based accounts, it was 0.85%, plus management fees (often another 1%). 

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. 

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