Kevin Greenard: Fixed income options becoming more complex as yields drop

Kevin Greenard

As a portfolio manager, we are always monitoring the direction of interest rates. For nearly two decades, the Bank of Canada (BOC) has adopted a system whereby they make eight scheduled interest rate announcements a year. The dates for 2020 are Jan. 22, March 4, April 15, June 3, July 15, Sept. 9, Oct. 28, and Dec. 9. In rare situations, there will be emergency meetings with corresponding additional interest rate announcements.

During these meetings, the BOC sets the rate of interest that Canada’s largest financial institutions pay to the BOC for borrowing money for one day. Because it is just for one day, it is often referred to as the overnight rate.

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On Oct. 24, 2018, the BOC increased the overnight lending rate to 1.75 per cent. For 11 meetings it kept the rate at 1.75 per cent. On March 4, 2020, it lowered the rate to 1.25 per cent. On March 16, it had an emergency meeting and lowered the rate to 0.75 per cent. On March 27, there was another emergency meeting and the rates were further reduced to the current rate of 0.25 per cent.

When the overnight rate changes, it normally impacts other rates that are more applicable to investors, such as the prime rate and mortgage rates. It can also affect the exchange rate. One would normally expect that when the BOC lowers interest rates that our dollar, relative to other currencies, should get weaker. If the BOC increases interest rates, then our dollar should get stronger relative to other currencies.

How have the interest rate changes impacted fixed income investments? The textbooks in finance classes always talk about bonds having an inverse relationship to interest rates. When interest rates go down, existing bond prices should increase. When equity markets decline gradually at the same time, the fixed income should be an offsetting positive.

Unfortunately, the textbooks should add a paragraph that deals with panic periods. During panic periods several things can happen: Markets become irrational on all fronts; bond markets suffer from liquidity issues; and many bonds are not trading, as no one is willing to buy (bid).

This is especially the case with corporate bonds. When equity markets decline sharply, many are willing to temporarily underweight fixed income by selling and buying the equities that have declined further. Also, the people who feel events are catastrophic sell because they fear that the underlying bonds may default.

We feel every client should have some portion in cash (discussed last week), a portion in fixed income (discussed this week), and a portion in equities (discussed next week). Having an understanding of the different ways of holding fixed income investments is the first step. Then, you can begin looking at the underlying risk, transparency, pricing (especially in times of panic), fees, and liquidity of each option.

Guaranteed Investment Certificates (GICs)

Term deposits and guaranteed investment certificates are a common way to hold fixed income. The return is known and all fees are built into the initial sell price. If you purchase a one-year $100,000 GIC at 2.0 per cent then you can count on receiving $2,000 in interest income and your original capital back in one year.
This certainty comforts a lot of people and the investment is easy to understand. It also makes it easier to plan your cash flows.

The yield is typically higher than a government bond and lower than corporate bonds. Most GICs are illiquid and cannot be transferred or redeemed before maturity. In order to get a higher rate, you have to commit to not having access to the principal for that duration (non-cashable).

GICs — Structured

Even in the GIC space we are seeing structured products adding a layer of complexity to a relatively simple fixed income product.

For example, there are market-linked or index-linked GICs where the principal amount that you put in is protected but you have the potential to enhance your return by linking the return to the performance of a specific market or index. With these types of GICs you typically do not get any cash flow during the period that you hold them and at the end of the term you could end up with just the principal amount that you put in.

We also see step-up rates where for the first few years the rates are under market rates and then they gradually climb. With the compounding of money, it would be more important to see the high interest rates at the beginning.

Many of these step-up GICs are cashable. If you cash it out before maturity, then you miss the years where the interest rate is highest. Prior to purchasing any structured investment, we recommend that you read the fine print and fully understand what you are purchasing.

Government bonds

For years, many Canadians would purchase Canada Savings Bonds (CSB) and Canada Premium Bonds (CPB). Due to significant declines in interest rates, 2017 was the last year that the government issued these.

Many of these simple fixed income options are disappearing in this low rate environment. To obtain government bond exposure, investors can still purchase direct government bonds.

Similar to CSBs and CPBs, the yields have been extremely low for a couple of years. At the time of writing this article, Canadian Government bond yields were as follows: two-year — 0.40 per cent; five-year — 0.583 per cent, 10-year — 0.710 per cent, and 30-year — 1.222 per cent.

After factoring in inflation and taxes, many investors have avoided government bonds after 2017. If someone is purchasing bonds because they feel a catastrophic event will occur, then government bonds would typically be the preferred choice.

Government bonds will typically maintain their price better than corporate bonds. The downside is that yields on government bonds are typically lower than corporate bonds.

Corporate bonds

Years ago, most new corporate bonds were syndicated through the large banks. We would get notification of a large bond offering and we could put in for an allotment to allocate to our clients. Our clients would typically hold 10 to 20 individual bonds from different issuers. These would be set up as a 10-year bond ladder.

The idea of spreading out the maturities was to reduce interest rate risk and issuer risk. It also ensured that a bond was maturing every year in the event that clients required funds or liquidity.

Today, many new bonds bypass the bank syndication and go directly to the large fund companies and exchange traded funds (i.e. Black Rock/iShares, Vanguard, etc.).

The alternative to purchasing bonds on a new issue basis is to purchase existing bonds. Direct bonds do not trade on a stock exchange which naturally makes the pricing of them a little less transparent.

When a client wishes to sell a bond, our firm purchases it from them as “principal.” Most financial institutions will have a bond desk and a bond inventory.

As portfolio managers, we call the bond desk up and they let us know what the price is. The bond then goes into our firm’s inventory, at which time they may either keep it or offer to sell it to someone wanting to purchase a bond.

If a client wishes to purchase a bond already issued and traded, then we can look at the bonds available in our firm’s inventory and on a system called CBID. CBID will list all the bonds of the participating registered dealers in Canada, not just our firm. CBID enables us to see the pricing and inventory of many more bonds.

Purchasing of direct bonds is still an option.

Exchange Traded Funds — Government

The iShares Canadian Government Bond Index (XGB) holds 371 government bonds. The mandate of XGB is to only hold investment grade government bonds with maturities of at least one year.

Bond prices should increase when interest rates decline, but that’s not what happened when interest rates dropped from 1.75 per cent to 0.25 per cent: On March 3, XGB closed at $23.06 per unit. On March 23, XGB closed at $22.68 per unit.

XGB initially declined 1.65 per cent during this period. The textbooks say that this should increase in value. This investment should have been an offsetting positive during this period.

With time, valuations tend to gravitate toward more normal levels. At the time of writing this column, XGB had increased and closed at 23.24. The current yield on XGB is 2.17 per cent.

As you will see from the next paragraph, the yield on the Corporate version of the iShares is higher; however, the price decline was far greater. Over the last month, investors would have fared better owning government bonds than investment grade corporate bonds — this is not normally the case.

Exchange Traded Funds — Corporate

Instead of purchasing individual bonds, many investors have purchased Corporate Bond ETFs.

Let’s look at the iShares Canadian Corporate Bond Index (XCB). This index holds 905 bonds. The mandate of XCB is to hold only investment-grade bonds with maturities of at least one year. We will look at XCB in relationship to interest rate changes.

On March 3, 2020, XCB closed at $22.33 per unit. On March 23, XCB closed at $17.40 per unit. XCB declined 22.1 per cent in 20 days — despite the drop in interest rates.

Any time you have a bond ETF, the pricing of the bond is not always clear. As the bonds do not trade on an exchange it can be near impossible to simultaneously verify the pricing of 905 bonds to determine the correct trading price.

At the same time that an investor may have wanted to sell XCB to buy equities, they were squeezed because XCB had declined so much. In many ways XCB was more correlated to the equity markets declining.

For the past couple of years, we have explained to clients how risk exists within fixed income. The speed at which people can sell bonds today within corporate bond ETFs (and other structures), and the pricing pressure this causes, is another risk to factor in. At the time of writing this column XCB closed at $21.80.

Bond Mutual Funds — Conservative

Another common form of fixed income investment is a bond mutual fund or a balanced mutual fund.

A bond mutual fund invests in a basket of fixed income investments. Depending on the fund prospectus, the mandate can result in significantly different structures between funds.

Not all bond funds are created equal. Some bond funds are very conservative while others may take on considerable risk.

Conservative bond funds may hold government bonds and investment grade (BBB rating or better) corporate bonds. Treasury bills, banker’s acceptances, and term deposits are all considered low risk and are common in conservative bond funds.

Diversification of fixed income can be done through holding different types (issuers), qualities (credit ratings), and maturities (mixture of short, medium, and long term).

The added “diversification” benefit of bond funds comes at a cost often referred to as a management expense ratio (MER). When interest rates are so low, it seems difficult to justify the higher MER.

Bond Mutual Funds — Aggressive

Over the past few years, financial products have been created in the fixed income space with complex strategies to try to enhance yield, and thus justify the higher fees.

Riskier bond funds do exist and have very different mandates than the typical conservative bond fund. Bond funds that hold non-investment grade bonds, also known as high-yield or junk bonds.

Some bond funds are issued under offering memorandum and lack transparency as they do not have to provide the same level of disclosure. Some have minimum hold periods, trade infrequently or lack liquidity.

Structured products offering complex strategies to enhance yield also have a much higher degree of risk and generally have a higher MER. Other funds may hold foreign bonds or concentrate in certain countries such as the United States, and the currency may be hedged or unhedged. We caution investors to understand the product prior to purchasing.

We encourage most investors to keep things simple. We recommend most investors avoid structured products or investments that lack transparency and liquidity.

Establish an asset mix and determine the percentage of fixed income that is suitable based on investment objectives and risk tolerance. It is important to rebalance periodically to ensure that your target fixed income component is maintained over time.

Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director, wealth management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138. greenardgroup.com

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