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Strategies for fixed-income investing in current conditions

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  • Apr 30th, 2020 8:00 pm
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Strategies for fixed-income investing in current conditions

My go-to fixed-income strategy was investing in an ETF that tracks a broad market index like the Canadian Bond Universe index (e.g., ZAG or XBB). The modern portfolio theory assumes that bond and equities are inversely correlated. Yet, my (limited in terms of time) experience was that their prices move in the same direction. I was going to sell my ZAG position (which I thought would appreciate in price) and take advantage of low prices during the market panic. I wasn't able to do so because the liquidity crunch made ZAG drop to 14$ in mid March. I lost precious time while waiting for its price to recover. Now, if I consider adding to my ZAG position in current zero-interest rate environment, I can suffer losses down the road if Bank of Canada decides to increase interest rates pushing bond prices down. Add to this the fact that broad-index bond ETF yields (2.5% or so) are on par with high-interest savings accounts.

What are your strategies for fixed income investing at the moment? Is it more beneficial to hold a few of carefully selected individual corporate strip bonds? Does it even make sense to invest in bonds in the current environment? Are blue-chip dividend stocks becoming proxies to bonds? Feel free to share your thoughts.
Last edited by stanleyinfrared on Apr 26th, 2020 4:19 pm, edited 1 time in total.
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It really depends on your personal financial situation, specifically the risk that you will be forced to sell off part of your portfolio to pay for your living expenses if you lost your employment income (obviously a risk that many of us share these days). If this risk is significant, consider selling off enough ZAG of and putting the proceeds into high interest saving account.

I would not consider any kind of stock to be a proxy for bonds.
Last edited by CheapScotch on Apr 26th, 2020 4:53 pm, edited 1 time in total.
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Regarding inflation and higher rates, there would have to be demand in the economy, and right now there is almost none. QE/bond buying would have to wrap up before any rate increase, so we're further from rate increases or inflation than we've been in recent times (arguably ever in Canada). That said rates might increase over the long term. Short or medium term very low probability.

In terms of fixed income, Canadian bank stocks are paying an average 6% dividend, and have not cut dividends since the 1930s. TD seems well priced right now at around $55, which is 2016 pricing, almost a 5 year low. CIBC's 5 year low was a few weeks ago and hasn't otherwise been as low as current price of $79 going back 5 years, sweet 7.49% dividend as well.

Of course stocks could keep going down, so your capital is never guaranteed, but there is a very high likelihood that you will continue receiving the dividend.
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stanleyinfrared wrote: What are your strategies for fixed income investing at the moment? Is it more beneficial to hold a few of carefully selected individual corporate strip bonds? Does it even make sense to invest in bonds in the current environment? Are blue-chip dividend stocks becoming proxies to bonds? Feel free to share your thoughts.
I ran into something similar with ZDB during the market plummet. I ultimately took a small loss to sell ZDB to buy some more equities... I don't regret that loss even a little.

Fixed income side of the portfolio is a huge pain right now. I am speaking from a non-registered perspective here, to set context. RRSP/TFSA has other limitations for fixed income due to not being able to easily access high interest savings accounts.

Since things have bounced back, I have moved a small amount into BXF (1-5 year government strip bond ETF which is tax efficient for non-registered accounts) https://www.pwlcapital.com/bxf-tears-st ... mpetitors/

However, the majority of my 'fixed income' is cash in a HISA at Tangerine which is currently paying 3%. Assuming they don't offer something decent when that promo is up, I'll probably move it back to Motive at 2.2%. It only takes me a couple of days to move the money around should I need it to purchase more stocks, and worst case I'll pay margin interest for a day or two. Not a huge deal.

I intend to keep my bond allocation pretty small, because:
https://www.canadianportfoliomanagerblo ... adventure/
"Key Takeaway #3. When the YTM of a GIC ladder is similar to or higher than the YTM of a bond ETF, it can be a decent alternative for a short-term or a broad-market bond ETF."

And right now, 2.2% in a HISA is better than most of the bond ETFs which are ~1.6% YTM, and have all of the downside when interest rates eventually rise.

Are blue chip dividend stocks proxies for bonds? Not to my mind - and I own a significant chunk via a Canadian dividend ETF. Fixed income is where the money goes when it is waiting for better opportunities and to help keep folks from losing their nerve when stocks drop 40%. Despite the challenges in selling ZDB when I wanted the funds, I was glad to have it to be able to purchase some of those dividend stocks when they dropped.
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Just to expand on what I said above, why stocks should not be considered a proxy for bonds:

https://www.nasdaq.com/articles/wall-st ... 2020-04-26
NEW YORK, April 24 (Reuters) - Companies across a range of industries are slashing or suspending dividends to cope with the economic fallout from the coronavirus outbreak, complicating the stock selection process for money managers eager to buttress their portfolios with a steady stream of income.

The past week's plunge in oil prices has potentially accelerated that process, raising concerns about the rock-steady dividends of companies such as Exxon Mobil XOM.N and Chevron Corp CVX.N, which are set to report results on Friday, May 1.

The S&P 500 dividend aristocrats index .SPDAUDT, which tracks companies that have increased dividends annually for the past 25 years and includes Exxon and Chevron, has fallen about 19% so far in 2020 as of Thursday, greater than the 12.9% drop over that time for the S&P 500 total return index .SPXTR.
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No special fixed income strategy here. Balanced ETF funds in the registered accounts swapped from a mix of index funds and ETF's earlier in the year. Registered portfolio returns since are down in the single digits. No big deal. Re-invested quarterly distributions earlier this month.

Outside of the registered it's just a hefty emergency fund in a HISA. The rest is in Canadian dividend growth stocks, although I've never felt it was a substitute for bonds. Just another form of income to re-invest.
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As a hedge, I have start dabbling in preferred shares via ZPR instead of bonds.
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Rothesay wrote: As a hedge, I have start dabbling in preferred shares via ZPR instead of bonds.
Interesting...never heard of preferred shares instead of bonds. Will certainly look into this.
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Rothesay wrote: As a hedge, I have start dabbling in preferred shares via ZPR instead of bonds.
In speaking from experience, and dealing with alot with the constituents held in ZPR, preferred shares of this type should not be used as a proxy for bonds, i.e. as a fixed income substitute. ZPR consists mainly of rate-reset preferred shares that are highly leveraged to the Government of Canada 5 year bond and overall/general market volatility. In the most recent downturn ZPR dropped 40% peak to trough, something that you don't want in a fixed income allocation. That said, if you treat it as part of your equity portfolio, you can do well buying at the lows (e.g. March 23) and hold a set of securities one step up in the dividend chain - preferred share dividend cuts are rare, in comparison to the large number of cuts we see today in common shares.
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As you have already noticed, you are correct. There is a huge misconception about how fixed income and bonds work: they are not perfectly inversely-correlated to equity nor should they be thought as such. Some people have equated bonds as a cash/emergency fund which is also incorrect. In most cases, bonds should always be considered a long-term investment, irregardless of them being safer than equity in general.

How you want to structure your portfolio shouldn't necessarily be on how much equity and how much fixed income you have. The biggest problem is that equity and fixed income are such broad categories in general. If I held a portfolio of equities consisting of large caps, vs a portfolio of penny stocks would be completely different risk. In the same vein, fixed income would act the same way. A longer term bond would be riskier than a short term bond as longer terms would be much more sensitive to interest rate changes.

So the best way to go about what you buy should really be based on your portfolio goals. There is not right answer, however depending on your timeframe, risks, and overall goals, you could look at many options.

Bond Terms

If you are a person with short term goals, say retirement is close-by or say you want to hold fixed income for the time being and want to immediately go about buying equity during a downturn, one option could be to look at short term bonds. Bonds with shorter terms are less sensitive to interest rate changes as price differentiation is much lower. They are also available as ETFs as well. As an example....

Vanguard

VSB Vanguard Canadian Short Term vs VAB Vanguard Aggregate Bond

MER 0.10% vs 0.08%

Terms: 1-5 years vs the entire spectrum

Yield: 2.31% vs 2.65%

With close to inversion of current yields, the yield difference between short and long term bonds has shrunk considerably. Of course in times where interest rates drop, longer term bonds will appreciate more than short term. But if you are solely looking for safety while reducing your risk, a shorter term bond can help protect you from interest rate hikes in the future.

You can see this in different years. 2013, VAB performed -4.87% while VSB -0.91%.

So if you are looking at possibly requiring cash short term, a short term bond ETF could be more appropriate.

GICs

Similarily to short term bonds, GICs can be another option. They are set terms and yield similarly to bonds at the moment. They also provide the price movement safety. Of course liquidity can be an issue, however for those wanting a regular, steady predictable yield, this is an option. For anyone even more skittish about markets, deposit insurance means your investment is fully guaranteed.

Debentures

These are not well known, however I believe these can be another option for those who want to invest in certain shares but are worried about future downturns that may be out of control of management. Debentures are similar to corporate bonds in terms of risk. But one nice option with debentures is that they often have conversion options. For instance, debentures issued by Exchange Income Corporation have equity conversion options. So say the share price were to exceed the target, you have an out to take advantage of higher share prices. Of course, this is inherently riskier. Additionally many don't trade well and trade with higher commissions with some brokerages.

Income Producing Equities (eg. Utilities, REITs, and Preferreds)

If your goal is yield or reducing your risk in equities in general, picking these investments could be another option. Yes as @STP123 has mentioned, they do not provide the same safety of fixed income. In terms of comparing equity though, they are somewhat safer than other equity issues. For instance preferreds even rate-resets have to be redeemed at par by most issuers. REITs and Utilities tend to represent industries that are more stable in general. People need electricity, people need apartments/real estate etc. (although real estate is much riskier at the moment). If however you are looking at a longer term portfolio but want income to allow ways to add cash to your portfolio, it is one way to go about it.

For instance instead of a 70% Equity and 30% Bond portfolio, you could allocate some of the equity or bond portfolio to make it work.

Example, if you want to increase your yield on equity portion, a 40% Index Equity, 15% REIT equity 15% Utility and 30% Bond could be one way to set a portfolio.

If you are worried about interest rate sensitivity, splitting a portion of your fixed income to preferreds is another option.
Eg. 70% Equity, 20% bond, 10% preferreds etc.

Individual issues

All of the above investments are also available as individual issue. Going this route can be advantageous in many cases. For debentures, this is the only option. Preferreds, many preferred shares are just aggregative and you may want to time the rate-reset to a certain time (eg. if you want to avoid rate resets that will reset in the next two years because you believe the downturn will mean no increase for a while etc.). Individual bonds can find you some higher yields with ways for your to vet the risk on an individual company/jurisdiction basis. Whatever you decide though, keep in mind lack of liquidity and often more expensive commissions.

Whatever you decide, it should work as long as it aligns to your timeframe and goals of your portfolio. There is of course nothing wrong with keeping it simple to a traditional stock and bond split. This has worked tremendously for many years especially for longer term views. However depending on your time frame and risk tolerance, you may want to alter it on the many options you have out there. I recommend trying to understand all your options, then ask yourself what you want from your portfolio, then build it accordingly.
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[OP]
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The question that fixed-income investors should be asking themselves is whether they are adequately compensated for the risk they are taking. Consider an investor holding shares of broad-market bond index, e.g., ZAG.

The risks are as follows:

1. Credit risk - very low because the investor is holding a diversified basket of bonds.
2. Interest rate and inflation risk - very hard to estimate, very likely higher than before because we are at all time low interst rates.
3. Liquidity risk - a common belief is that it is very low, because shares are freely traded at exchanges, and the volume is high. But ZAG dropped by 16.5% in March over a week at one point because of liquidity crunch. This does not look like a low risk in my opinion.

Return:

The yield to maturity is 1.6% at the moment. The management fee is low, but non-negligible (0.08%).

The investor can easily find a HISA with 2.2% interest rate, essentially zero downside risk and perfect liquidity. So, are ZAG holders adequately compensated for the risk they are taking at the moment? In my opinion, the answer is no.

EDIT: this analysis applies to a bond ETF, and the verdict may not be accurate for other fixed-income products.
EDIT2: changed the YTM for ZAG
Last edited by stanleyinfrared on Apr 28th, 2020 7:33 am, edited 4 times in total.
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Good analysis. And I agree : they are not compensated. That's why bonds are not part of my portfolio anymore and will never be. Not saying either go all in with 100% stock portfolio.
Just keep some cash on hand (any form) !
stanleyinfrared wrote: The question that fixed-income investors should be asking themselves is whether they are adequately compensated for the risk they are taking. Consider an investor holding shares of broad-market bond index, e.g., ZAG.

The risks are as follows:

1. Credit risk - very low because the investor is holding a diversified basket of bonds.
2. Interest rate and inflation risk - very hard to estimate, but very likely higher than before because we are at all time low interst rates.
3. Liquidity risk - a common belief is that it is very low, but shares are freely traded at exchanges, and the volume is high. But ZAG dropped to by 16.5% in March over a week at one point because of liquidity crunch. This does not look like a low risk in my opinion.

Return:

The yield to maturity is 2.6% at the moment. The management fee is low, but non-negligible (0.08%).

The investor can easily find a HISA with 2.2% interest rate, essentially zero downside risk and perfect liquidity. So, are ZAG holders adequately compensated for the risk they are taking at the moment? In my opinion, the answer is no.
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stanleyinfrared wrote: The yield to maturity is 2.6% at the moment. The management fee is low, but non-negligible (0.08%).
Sorry but where do you see such high YTM?? It’s been under 2% for as long as I remember, and now it’s 1.61%: https://www.bmo.com/gam/ca/advisor/prod ... file%2FZAG (Weighted Average Yield to Maturity) VAB and its benchmark quote 1.8%.

Other that that I concur :)
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stanleyinfrared wrote: 3. Liquidity risk - a common belief is that it is very low, because shares are freely traded at exchanges, and the volume is high. But ZAG dropped by 16.5% in March over a week at one point because of liquidity crunch. This does not look like a low risk in my opinion.
It dropped 16.5% very briefly in response to an unprecedented set of circumstances, but came back up almost all the way within a month.
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freilona wrote: Sorry but where do you see such high YTM?? It’s been under 2% for as long as I remember, and now it’s 1.61%: https://www.bmo.com/gam/ca/advisor/prod ... file%2FZAG (Weighted Average Yield to Maturity) VAB and its benchmark quote 1.8%.

Other that that I concur :)
Sorry, typo. I meant 1.6%. You mentioned that you invest in individual corporate bonds in other thread. How has your experience been so far? What made consider this? Would you mind elaborating?
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CheapScotch wrote: It dropped 16.5% very briefly in response to an unprecedented set of circumstances, but came back up almost all the way within a month.
Sure, but that's because the equity market rebounded quickly. What would have happened if that hadn't been the case?
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stanleyinfrared wrote: Sure, but that's because the equity market rebounded quickly. What would have happened if that hadn't been the case?
The point I was making is that a single, very rare and transient event is inadequate evidence to draw a meaningful conclusion about the riskiness of bonds.
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stanleyinfrared wrote: Sure, but that's because the equity market rebounded quickly. What would have happened if that hadn't been the case?
+1 for realizing that.

Correlations go to one in times of global financial stress.
Thread: "what happend to bonds yesterday? 6% drop??" = what-happend-bonds-yesterday-6-drop-2361188/#p32271612

As opposed to trying to impose my view as @CheapScotch does in every thread he posts in, I'll refer you to some past posts, a proxy for market risk and let you go through them yourself.
market-timing-step-2-going-back-2361111/19/#p32305470
market-timing-step-2-going-back-2361111/20/

As a long term market participant, pick a date out on the VIX chart where it spiked and I'll tell you how "bonds," rates and credit, performed. Guaranteed you won't need to ask me, because of correlations.
http://www.cboe.com/index/dashboard/VIX#vix-performance

There is not one type of equity, there is not one type of person and there is not one type "bond".
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