With interest rates at historic lows, investors entering retirement may be struggling to secure adequate income from their investments – particularly where capital preservation is also a priority.
Investments deemed relatively “safe” have historically been a dominant holding for many investors – with bonds and cash-equivalents delivering respectable returns through the accumulation phase for most baby boomers. As bond yields have fallen over the past 30 years, so too has the total return expectation of holding these bonds. The chart below shows how forward returns have marched lower, in lock-step with bond market yield-to-maturity.
Source: Morningstar Research Inc. and Bloomberg L.P., data from January 1, 1976 to December 31, 2016.
While falling rates benefited bondholders at the time, the resulting low-rate environment is undermining the role of the least risky investments – high-interest savings accounts, GICs and short-term government bonds – in providing meaningful returns.
Traditionally the foundation of a portfolio, these lower-risk assets are now yielding less than the rate of inflation, thereby eroding purchasing power over time. The chart below illustrates these below-inflation yields relative to the yield-to-maturity of a short-term investment grade bond ladder strategy – PowerShares 1-5 Year Laddered Investment Grade Corporate Bond Index ETF (PSB).
Source: Bloomberg L.P., Bank of Canada and Manulife Financial Corp., as at December 31, 2016. For standard performance data, please see link to PSB fund information at the end of the post.
Reaching for yield
To address this problem, many investors have moved further out on the risk spectrum, seeking enhanced yields on their fixed-income allocations. The riskier of fixed-income assets, such as global bonds, high-yield bonds, emerging-market debt and asset-backed securities, have made their way into the core of many popular strategies over the past few years.
Have investors overreached?
These higher-yielding asset classes may prove more volatile than many investors expect, leading them to flee during corrections and ultimately increasing the risk of permanent losses.
An alternative path is to take a much smaller step out on the risk spectrum, embracing short-term, investment-grade bonds from Canadian corporate issuers. This approach leaves less room for an investor misstep – with no foreign exchange-rate risk, minimal credit risk and less duration risk – while still offering a yield pickup over cash equivalents. The chart below illustrates the lower volatility of short-term, investment-grade Canadian bonds relative to other riskier fixed income asset classes.
Source: Morningstar Research Inc.
Equal-weighting bonds using a laddered approach can further mitigate potential problems. As illustrated below, equal-weighting reduces concentration risk, while laddering the bonds by maturity buckets reduces the risk of reinvesting at an inopportune time.
Source: Invesco Canada, as at December 31, 2016.
While there’s no doubt that income needs are becoming more difficult to meet as the low-rate environment continues, with the right approach, the fixed-income space can still be a meaningful contributor to portfolio returns.
For investors and advisors looking for enhanced yield, less interest-rate sensitivity and management of reinvestment risk, the strategies below may provide opportunities.