Keeping Your Fixed-Income Fire Extinguisher Within Reach

06.16.2016 By , Jason Brink

On May 3, 2016, James Redpath, Portfolio Manager at Mawer,  guest blogged on Findependencehub.com. With permission from Findependencehub.com, we thought we would share. 

Bonds are boring. They’re supposed to be. In the relatively dry world of finance, one of the valuable functions bonds provide is to increase the diversification and resilience of a balanced portfolio by serving as a fire extinguisher when times get tough, not as an accelerant.  They’re designed to make money, but they’re also meant to manage any potential sparks or flare ups lit by their flashier equity counterparts. While no one’s pulled the alarm in this new realm of negative interest rate policy imposed by certain central banks, it’s still a good idea for fixed income investors to be aware of their bond holdings and check to ensure that, like a fire extinguisher kept in the kitchen, they’re still appropriate and ready to do the job they’re meant to should the need arise.

What’s happening with negative interest rates?

In 2014, the European Central Bank became the first major central bank to shift interest rates into negative territory.  The central banks of Sweden, Denmark, Japan and Switzerland followed suit soon after.  Negative interest rate policy is a signal that the more traditional policy options have been ineffective and new boundaries need to be explored in order to achieve each central bank’s individual mandates for the role they serve within each country and the broader global economy.  Up until 2014 there was no modern historical precedent of negative interest rate policy.  The typical mandate of a central bank is to target a low and stable inflation rate.  In theory, raising interest rates usually slows down the economy and reigns in inflation, while lowering interest rates usually increases economic growth and inflation.  If inflation is positive, low and stable, the future is more predictable for businesses and individuals to plan their investing, borrowing and consumption requirements.

In theory, negative interest rate policy is intended to incentivize banks to extend loans to businesses and individuals which increases demand for loans, and therefore encourages economic growth.  Whatever cash that is leftover (and eligible in the banking system after day to day operations) is held on deposit at the central bank at negative interest rates.  In essence, private sector banks are being penalized.  Until recently, this was unheard of in modern history.  Usually if you borrow money, you have to pay interest on it. This has been the foundation of our banking system for centuries. So it’s a pretty radical concept that banks have to pay the central banks in order to simply give them their excess cash balances.  So far, banks have absorbed these costs and not passed on the negative interest rates to retail account holders. This ultimately can affect the profitability of the banking system and can become risky not just for banks but for the economy in general.

Falling expected returns on high-quality bonds

Negative interest rate policy, bond purchases by central banks, aging demographics, low growth, low inflation and increased uncertainty have lowered expected bond returns on high quality bonds. This has put pressure on investors to move further away from the familiar protection of their traditional fire extinguishers into riskier, more exotic alternatives with the hope that they may offer higher returns.  At the same time, it has forced people to think more long-term—beyond the instant gratification of buying “stuff” and more about their desired nest egg amounts.  And, of course, the more money people put towards their retirement goals, the less they have to contribute to overall consumer spending.  This is a powerful side effect that is an increasing threat to the main goal of negative interest policy—which is to increase demand for loans.

The world is still trying to make sense of negative interest rates. During a recent trip to Sweden I was told from the RiksBank (Sweden’s central bank) that their banking system was not designed to receive interest payments from holders of floating rate bonds when they dropped below zero.  When floating rate bond yields went below zero the yield was assumed to be zero and the holder did not have to make a payment. This is indicative of many systems that were simply not built to incorporate negative interest rates.

Other anomalies are occurring as well. A recent article in the Wall Street Journal chronicles how one Danish couple is actually getting paid interest on their mortgage. As in Sweden, consumer savings accounts pay no interest and real estate is booming. Instead of paying interest on the loan they acquired a decade ago to buy a house, their bank paid them the Danish equivalent of $38 in interest for the quarter. By the end of the year their mortgage rate, excluding fees, was – 0.0562%. The bank would likely recoup this loss in other ways (e.g., ATM fees and other charges), but what’s happening in Scandinavia may provide a glimpse of the topsy-turvy effects negative interest rate policies can have on the world.

What does this mean for bond investors?

So what are the implications for bond investors and how tough will it be for people to reach their investment goals in this environment? Unfortunately there’s no easy answer. Ultimately, you need to choose between staying the course, recognizing that expected bond returns may be lower in the future, or abandoning ship and increasing the overall risk you’re willing to take in your portfolio in order to earn a potentially higher return. We believe that the best strategy moving forward is to keep your fire extinguisher handy, focus on longer term investment and maintain a balanced, diversified portfolio. Whatever you decide, it’s important to be aware of your bond exposure, or lack thereof, because if you choose to increase the risk profile or not to have any exposure you could be indirectly increasing the risk of your overall portfolio.

 

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7 Comments

  • Reply
    Doug Munton
    06.16.2016 at 9:19 am

    So rather than have a very minimal return on a bond , why wouldn’t one hold a Pfd reset knowing that in five years you will get the gov’t 5 yr rate plus whatever the reset amount is , in some cases 3-4% or more . I just can’t understand these resets trading down so much .

    • Reply
      B. Clark
      06.18.2016 at 9:27 pm

      I’m baffled by the pref mkt as well. Perhaps as return expectations decline over time, the value of higher quality issues will increase.

    • Reply
      Marc L.
      06.21.2016 at 11:40 am

      I am hoping somebody from Mawer will weigh in on your question, because I think is a good one.
      My guess is that while there are a number of Pfd shares with good yields and even better returns once you factor in the tax implications, and there are a number of series where there is scope for capital gains too if the shares are called in, the main problem is their lack of liquidity. So if a portfolio has cash to spare or other liquid assets, holding Pfd makes a lot of sense to me, but I don’t think I’d build an entire portfolio or even the conservative part of a portfolio using them exclusively or for a major portion.

    • mm
      Reply
      James Redpath
      07.14.2016 at 10:43 am

      (1) To achieve proper diversification, it would be important for an investment portfolio to have an appropriate diversification strategy of cash, fixed income, and equities. In times of crisis, investors tend to go to larger and liquid markets; for example, government bonds denominated in reserve currencies such as the US dollar and the Japanese yen; as opposed to the Canadian preferred share market (which is very limited , retail based, and is denominated in a currency that is known as a petro-currency).

      (2) Interest income is a contractual obligation of the company. A company can cut its preferred dividends in difficult times. Hence, preferred shares should not replace or be a substitute for fixed income; as fixed income is critical to providing portfolios with recurring income; downside protection; and building investment portfolios that are resilient in difficult times.

      (3) Nobody knows what the direction of interest rates will be and hence, betting on the direction of interest rates can be a difficult proposition even when you believe the odds are in your favour. For example, prior to the BREXIT vote, most thought the US was likely to raise short term rates. This view has changed somewhat given Britain’s decision to leave the Eurozone. Moreover, in this environment of slower global growth and perhaps even lower yields, rate reset preferred shares may experience more divided cuts and more price volatility. Please see link below https://www.youtube.com/watch?v=vJVoul-iofo

      (4)Most Canadian investors’ earning power (jobs) and their overall net worth tends to have high exposure to Canada and the Canadian dollar. For instance, their primary residence is domiciled in Canada, and the composition of the average Canadian investment portfolio tends to have a home country bias (over weight Canadian equities). It is important that Canadians increase the resiliency of their net worth to macro events that have a large influence on the Canadian economy (price of oil), by having greater exposure to financial assets or investments that are less correlated to the Canadian economy. Substituting Canadian preferred shares for a diversified fixed income portfolio (that includes Global Bonds) may increase one’s overall financial risk as opposed to reducing the risk.

      • Reply
        Doug Munton
        07.15.2016 at 9:42 am

        James I doubt that Royal Bank will cut their dividend on the Pfd Shares they have issued . If they ever did I would suggest the bond issuer’s would be defaulting on their interest payment as well .
        If one considers the tax effect on interest income versus a dividend , ones return is next to nothing .
        I really quite like a 6 % dividend today , knowing that at reset time I am looking at Canada 5 Yr Rate plus a known number . And it does give me the income stream that I want at a preferential tax rate .
        Further , I think we have to be cautious about this global diversification theme . I see nothing but trouble throughout the world , and that means a lot of risk . For the most part , other than North America , I am very cautious .

  • Reply
    Mark Scanlon
    06.17.2016 at 2:16 pm

    I find this concept very difficult to grasp. It seems to me that we should possibly be considering (whether through direct purchase, or with a dividend-producing mutual fund) the dividend route more thoroughly- through large, high quality companies with a good history of increasing dividends.
    Comments appreciated

  • Reply
    A. Pundzius
    06.23.2016 at 8:10 pm

    I find these comments not only interesting but also enlightening. We are in such a fluid monetary environment that every bit of information is helpful to better determine how
    to handle our portfolio for future times.

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