THE BLOG
07/15/2011 09:40 EDT | Updated 09/14/2011 05:12 EDT

Don't Stretch for Yield

For many Canadians on a fixed income, the last 10 years have been tough, to say nothing of the most recent couple.

In an ultra-conservative portfolio, filled with Guaranteed Investment Certificates (GICs), five-year rates have spent most of their time below 5% and have hugged the 3% level for much of the past year. With average annual inflation running at 2% and price increases higher for a lot of the non-discretionary items that seniors purchase, the yield erosion has been more acute.

Last year, investors were treated to something a little rare among G7 countries and that was a move by the Bank of Canada to raise interest rates, but what many forgot is that the rates they get on GICs at their local bank or brokerage have less to do with what the Bank of Canada is doing and more to do with how bond markets are performing.

Bottom line, the Bank controls the extreme short-end of the yield curve with its overnight rate target (currently at 1%), GIC rates take their cue from bond yields and mortgage demand. When bond yields go up, GIC rates will tend to move higher to because of the competitive effect. Likewise, if mortgage demand goes up in general, or perhaps in a particular term, lending institutions will tend to offer higher rates on GICs to attract the funds needed to satisfy the extra demand. This is exactly why GIC rates are lower today than they were about a year ago, even though the Bank of Canada's rate is half a percent higher. The bad news is that things are unlikely to change any time soon.

While some European countries are going through a gut-wrenching jump in government bond yields as a result of debt default concerns, that is not the case in Canada. Nor will it likely to become a concern, even if Ottawa fails to balance its budget in four years as planned. In a world where the US government is routinely running trillion dollar deficits, even if Canada misses on its target it will still retain its poster child status.

However, as folks become more anxious over European debt markets, they gravitate to the safer havens of the world, including Canada. That demand for refuge actually puts downward pressure on Canadian bond yields, which in turn puts a lid on GIC rates. At the same time, economic headwinds around the world ensure that growth among the developed nations of the world remains below the pace needed to cause real inflationary pressure, and this keeps central banks on the sidelines in terms of hiking rates. Yes, I know I said the Bank of Canada isn't having much impact on those rates posted in the window, however, if the Bank were to signal a need to jack its rates higher to cool demand and/or inflation, markets would take their cue and force bond yields up, leading to juicier GIC rates.

There are two strategies to take in this environment, other than altering the mix of assets in your portfolio (which should always be done in relation to a change in objectives and risk tolerance). The first, and preferred, strategy is to be patient. If you invest in GICs, stick to a five-year ladder and don't try timing things like monetary policy changes by investing in one-year rates in anticipation of higher rates down the road. It could happen, but then again it may not. For a refresher on the success of timing, have a look at what happened to GICs in the second half of last year. The preferable strategy is to maintain a medium-term bond ladder which gives you the added benefit of potentially better yields than GICs, but also the potential to generate capital gains if the doom and gloom economic predictions come true over the next five years.

What you should not do is stretch to make more yield. This includes loading up your portfolio with high risk (junk) bonds, but it also applies to not going out and buying long-term bonds, even if they are government issued. Yes, we all expect Ottawa and the provinces to remain solvent for many many years to come, but when global interest rates really do start to climb, the capital invested in long-term bonds will erode.

Many investors don't realize that a 1-2% increase in 10-year bonds yields can cause a correction of 10% in the value of those bonds. If you don't need the capital for 10 years and you're satisfied with the paltry yield you'll get for those years, it may not seem like a problem; but if you do need that capital at some point you might be in for a shock.

Maintaining a medium-term portfolio allows us to buy and hold to maturity. We don't really care too much if yields spike in the near-term, because we have locked in a return for those years (assuming the government or company in question doesn't go under). We'll get back our nominal investment and have the capital to go and re-invest. If rates are higher by then, all the better.

It all comes down to patience -- probably the most valuable asset you can invest in these days.