Retirees, baby boomers and conservative investors are being punished by the policy of the Bank of Canada and low interest rates.
That does not mean that Governor Poloz is implementing the wrong strategy as his job is to stimulate the economy, control inflation and ensure stability in the financial system. This is a very difficult balance in today’s world. Reality is that the end result has punished income investors as interest rates are down in the 1-3% range. Fortrus will provide an overview of different strategies and products an investor could consider when investing for income.
Income investing must be assessed based on a number of criteria:
- Actual return on the investment
- Is the return guaranteed or variable
- What is the tax treatment of the income
- Is the principal invested guaranteed or not
- Is there liquidity in the investment
- Will the price of the investment vary in price
- What is the risk on your capital
- Is there a set term for the investment or is it perpetual
In today’s world, the safer and shorter the term of the investment, the lower the yield. Generally speaking, you want to be invested in shorter term securities when interest rates are rising. This would be in an environment of high inflation and solid economic growth. Our world today is at risk of higher inflation but growth is muted. This has allowed the Bank of Canada to keep interest rates low. When interest rates are expected to fall, an investor should lock in longer term rates. It is also a prudent strategy to ladder or stagger maturity dates which lessens your interest rate risk.
One other important consideration is if the investments are guaranteed under the Canada Deposit Insurance Corp (CDIC). A Canadian has up to $100,000 per institution of guarantees by this Federal government subsidiary. Many of our banks have a number of entities within the parent company that can provide this CDIC insurance. Therefore in a number of institutions a Canadian can set up guarantees for up to $300,000 or more.
Conservative Fixed Income Investments:
Guaranteed Investment Certificates (GIC) and Term Deposits– these are issued by financial institutions with a fixed term and interest rate attached. They are not very liquid (ability to sell them prior to maturity) and therefore do not change in price quoted. As long as these are issued by a registered institution, these would be guaranteed under CDIC.
Government bonds – issued by all levels of government including Federal, Provincial and Municipal. They offer many features with the most common being a guaranteed interest rate paid semi-annual; a set term up to 30 years; liquidity as they trade in a secondary market; and are guaranteed by the underlying issuer. Price of bonds will go up if interest rates fall and down if interest rates rise. The change in price will be greater for longer term bonds. An investor can also buy foreign bonds that pay in Canadian dollars or other currencies. A foreign bond issued in their local currency adds ones additional component that must be assessed and that is currency fluctuation. There are also ‘real return’ bonds that are indexed to the Consumer Price Index (CPI) or inflation.
Corporate bonds and debentures – same principals as government bonds but are issued by corporations. The guarantees of these bonds are by the underlying corporate issuer and may offer chattel in guarantees. Here it is important to ensure that the corporation issuing the bond is safe and will honour both interest payments and is in a fiscal position to pay back principal at maturity. Bond prices will change based on interest rate changes like government bonds. Their price will also change based on the perceived risk of the corporation and will change if that risk changes.
Mortgage Backed Securities – fixed-rate investments that represent an ownership interest in a pool of many mortgages. Each month you’ll receive a proportional share of the interest and principal payments associated with those mortgages. In most cases, 4% to 6% of the principal is paid back to you over the life of the investment. These investments are fully-guaranteed by the Canadian Mortgage and Housing Corporation (CMHC), an agency of the Government of Canada.
Short term interest bearing investments – these are securities that will generally mature within a year. The types of investments include treasure bills, commercial papers, bankers’ acceptance, money market funds, and bonds/stripped bonds of maturity less than one year. Alternative types of income investing are available to investors. It is important for investors to do their due diligence as many of these investments change in price. They have the potential to provide capital gains or losses depending on the economic conditions; company fiscal position; change in interest rates in the economy; and overall demand for the security.
Preferred shares – issued by banks and other corporations. These are shares in a for-profit corporation that has some kind of special right or privilege attached to it, such as that it is distinguished from common shares by its dividend policy. Another is for the preferred shares to be redeemable or retractable at the option of either the holder or the issuing corporation. Usually preferred shares have no voting rights. They generally provide guaranteed quarterly dividends. They would only be suspended if it was required with deteriorating financial conditions at the company. They are liquid with the price fluctuating based on interest rate changes and stability of issuing corporation.
High Yielding Common shares – these are similar to preferred shares but their price tend to fluctuate with the fundamental changes of company financials – improved earnings tend to push price of the underlying security up, weaker earnings down. Dividends on these shares are higher than the average common share but lower than preferred shares. They are purchased for both the income as well as the potential capital gains.
Master Limited Partnership (MLP)– these are companies that are registered as limited partnerships (LP) with the partnership deriving a minimum of 90% of its cash flows from real estate, natural resources or commodities. These are investments that combine the tax benefits of a limited partnership (the partnership does not pay taxes from the profit but is only taxed when the unit holders receive distributions. The shares are liquid and trade on a stock exchange. Yields tend to be higher on these investments, averaging in the 6-7% range. They should be considered when one expects their underlying commodity focus is rising in price. MLP’s have been able to increase distributions by investing capital in excess of the cost of capital.
Income Trusts – these are investment trusts that hold income-producing assets. It trades like a stock on an exchange, holding assets which will generate a steady flow of income. The income is passed on to the unit holders, distributing a high portion of profits to unit holders in a similar way dividends are given out by companies. Because the cash goes directly to holders, income trusts have some tax advantages, such as avoiding double taxation. Some of the most popular income trusts are real estate investment trusts (REIT’s) and natural resource trusts. There are also business and utility trusts. The main attraction of income trusts is their ability to generate constant cash flows for investors.
Exchange Traded Funds or Exchange Traded Notes – are diversified portfolio of income bearing investments in the underlying objective of the fund. They generally seek consistent monthly cash distribution with the potential for modest long-term capital growth. This allows you to be immediately diversified in an income class at a low cost.
Income Mutual Funds – similar to ETF’s but the money manager has the discretion to purchase different securities in the portfolio trying to outperform the underlying index. Fees tend to be 3 to 4 times an ETF which makes them less attractive. Some managers have consistently outperformed their benchmark, making them well worthwhile to consider.
Overall investing in income producing securities is as difficult as it has been given the fact that Bank of Canada bank rate is as low as it has been in over 80 years, currently at 1%. An investor should truly understand the fundamentals of equity based income producing investments as the risk of capital loss or declining income is always there. Capital gains, interest and dividends are all taxed differently (listed in order of lowest to highest) so this is an important consideration; diversification among different income producing securities; staggering maturity dates of securities; and managing the portfolio ongoing are all factors in deciding what type of investments to purchase.