My Uncommon Approach To Providing For Income
We live in interesting times. Specifically, we live in a time where many people have known nothing other than getting superior returns (both the absolute and the risk-adjusted kind) in bonds relative to stocks for their entire investing lifetimes. That, in turn, could have led to some perverse thinking regarding risk and return. It could also leave a number of people shocked one day in the future when they review their quarterly statement and find that their ‘whistling past the graveyard’ attitude toward traditional income was, in fact, riskier than they thought.
As most readers will know, interest rates have been at rock bottom levels in Canada for about four years now. This, in turn, has caused some mighty consternation on the part of thoughtful advisors who have recognized the anomaly described above. Before delving into what to do about the situation, I thought it might be useful to provide a bit of context.
To begin, let’s look at some numbers. Morningstar Andex puts out annual charts to show how different asset classes have performed over time. In the period from 1950 to 2013, Canadian Stocks (the TSX) have returned 9.9% compounded annually, but Bonds (DEX Long Bond Index) have returned 7.5%. That 2.4% differential (risk premium) is low by historical standards and the reason for the relatively narrow spread can be seen in the performance numbers over the past few decades. In the 1980s, bond returns beat stock returns 13.7% to 12.2%. In the 1990s, bonds beat stocks 11.6% to 10.6%. In the first decade of the 2000s, bonds beat stocks 7.8% to 5.6%. So far in the 2010s, it looks to be a close race with neither asset class doing clearly better. In short, we’re looking at a 34-year trend where the asset class that has traditionally underperformed has nonetheless outperformed. That, alone, could signal that we are in for the mother of all reversions to the mean. Going back further, it should also be noted that the ‘40s and ‘50s were both “lost decades” where bond investors earned essentially nothing for their trouble.
The whole reason for this one-third of a century long outlier of a bull market in bonds is the ridiculously high interest rates that were prevalent in the ‘stagflation’ days of the very early 1980s. Starting from that insanely high level, rates dropped quite steadily for three full decades and finally settled in at the similarly ridiculous low levels we’ve been at for the past few years.
I don’t know about you, but by the beginning of 2011, I had become quite worried about what might happen next. From that unprecedented low level, virtually any rate hike would mean a person invested in bond mutual funds or bond ETFs would lose at least a little bit of money over short to medium timeframes. As with many advisors, preservation of capital is a high priority and I was determined not to have my clients invested in those sorts of products when the hikes came - so I looked for alternatives.
In Q1, 2011, I settled on what I would do – and I’ve been taking a fair bit of heat from a number of friends and colleagues ever since. I decided to recommend that my clients put the lion’s share of their income positions into Equity-Linked GICs (ELGICs). This is where I stop, pause and wait for you to catch your breath.
Hear me out. I originally thought I would be recommending ELGICs for “only a few years” (while we endured what I thought would be an inevitable round of rate hikes) and then we could go back to bond ETFs and bond funds. Well, nearly three and three quarters years have gone by, we still haven’t had a single hike and central bankers are making it sound like it might be a good while still before we see any change in monetary policy. In short, it seems that in hindsight, I may have been a tad early in my recommendation. Obviously, hindsight is 20 /20 and I believe most people would agree that my reasoning looked timely when I started. Rob Carrick of The Globe and Mail wrote an article about what I was doing over a year ago. If interested, please read: http://www.theglobeandmail.com/globeinvestor/ investment-ideas/a-radical-rethink-of-bonds/ article14446547/#dashboard/follows/
Over the years, with a starting point of March, 2011, I recommended new ELGICs every 8 or 10 months or so. As of now, I’ve recommended nearly a half-dozen ELGICs to my clients and most own 2 or 3 of them – the first one having matured in September, 2014. Seeing as this could take a while (i.e. “only a few years” might actually take over a decade), I have since taken to having my suppliers come up with products that are timed to mature at least once a year, so that there will be a ladder strategy in play.
My friends have commented that, if preservation of capital is genuinely the pre-eminent driver of the recommendation, then that can easily be accomplished by building a traditional bond or GIC ladder. I acknowledge that that would indeed be possible. The problem is that whether you’re buying short term bonds, longer-term bonds or GICs, the promised return in all cases is pretty anemic. Most institutions are paying about 2% on 4 year GICs and the yield on a 10-year Government of Canada Bond is also about 2%. Obviously, that could be enhanced a bit by lowering credit quality, but I don’t want my clients to have to “reach” for yield. At any rate, let’s assume that a guaranteed 2% return is the de facto hurdle that any alternative income strategy would have to beat. It would have been a piece of cake for previous generations. These days, it is more of a challenge.
Let’s begin the comparison by looking at a composite of the products I’ve used so far. I say composite, because each product has been a little bit different from the others, but there are nonetheless enough similarities that I believe a fair picture of the general attributes can now be painted. The ELGICs I have used have all been a structured “basket” of 20 Canadian dividend-paying stocks. Maturities have ranged from 3.2 to 5.0 years, so let’s use four years as a standard. These 20 blue-chip stocks (equal-weighted at 5% each) typically have a dividend yield of about 4%. Investors do not receive these dividends – ever. Instead, investors receive varying percentages of participation (less for short time horizons; more for long ones) of the price appreciation of the 20-stock basket. At four years, a reasonable assumption might be 100% participation.
For example, let’s say that the basket earns a 10% annualized total nominal return over those four years. The investor would receive 100% of that 10% return less 4% in dividends - or 6% in total. If the market were to grow at 8% annualized, the client would receive only 4%. However, if the market were to grow at 4% or less, the client would receive nothing, but would nonetheless have her principal protected. Therefore, if the 20 stocks were to drop by (say) 6% over that timeframe, the investor would still get her money back.
The net effect of all this is that, for the income portion of a client’s portfolio, the money is not so much beholdento the vicissitudes of the interest rate environment, butrather to the (truncated) vagaries of the Canadian stockmarket… lower highs – but no losses. There are lots of things to consider when changing recommended productsas a result of changed circumstances. Let’s examine this change from a few important perspectives.
Financial Planning
Most financial advisors write financial plans, do independence calculations and write Investment Policy Statements for their clients. To my mind, in order for that good work to be credible, it has to dovetail fairly seamlessly with what is expected from the client’s portfolio. My IPSs assume that my clients’ income portion return will be 1.5% real (above inflation). With inflation runningat about 2%, that means I’m projecting a total, nominal return of about 3.5% on income investments. It should be obvious that if I were to recommend products that wereonly keeping pace with inflation, the only honourable thing to do would be to lower the real return expectation in my IPSs to 0% real. We’ll discuss how realistic this is later on. For now, I just want to establish a rationale.
Probability of Gain
The underlying portfolios are based on the values of 20 Canadian stocks. It should be noted that the Canadian large cap stock market (TSX) stood at about 15,000 at the end of Q2, 2008. As I write this early in Q4 of 2014, the TSX is closer to 14,500. Stated a bit differently, the Canadian market is actually still down by about 3% over the past ~6.25 years. If history is any guide, you might know that there’s only a small chance that any developed stock market might be in negative territory over a full decade. One might argue that the point of losses being unlikely is moot, given the principal protection feature. I agree. My simple point is that the logical flip side of that argument is that a gain is highly probable, given the low starting point.
Downside Protection
As mentioned previously, people in bond ETFs and bond funds might very well see negative year over year returns if they maintained their positions. While it can be said that the point is of small consequence if people simply hold their positions for longer timeframes, I would point out that many retail investors might be inclined to react emotionally and do something rash. Offering principal protection provides a piece of mind to clients of low to moderate sophistication that the income portion of their portfolio is entirely secure.
Annual Income
This was something that I admit I hadn’t fully thought through in 2011. As I came to see that I might be using ELGICs for a long time still, I realized that I needed to use a ladder strategy so that there will always be at least one GIC coming due annually. That way, conservative people (many of which would have annual RRIF payment obligations) would have sufficient liquidity to deal with the government mandated withdrawals from registered plans.
Portfolio Re-Balancing
A small portion of clients’ income positions needs to be placed into other, more liquid products. This is not only due to the point above, but also for re-balancing. If you’re a young person with an allocation of 30% income and 70% equity and the stock market drops by 20% but you don’t have new money to add, it would be helpful if you could sell something from your income position in order to buy some stocks while they’re on sale – and re-balance your portfolio back to the stated 70/30 target in the process.
Tax Considerations
I only recently thought about how investors could do one better in taxable accounts. As you may know, when ELGICs mature, the income they generate (if there is any) is characterized as regular income, which is taxable at the investor’s top marginal rate. However, if the investor wanted the same basic value proposition (principal protection, but with a muted upside) while investing in a taxable account, he could also use a Principal-Protected Note (PPN) instead. There are a number of similarities between ELGICs and PPNs, but two main differences. After a certain holding period (typically one year), PPNs can be sold on the secondary market. The principal protection feature only applies upon maturity, but at least there is a mechanism for liquidity prior to maturity. Secondly, as a result of this liquidity, when a PPN is sold at a gain prior to maturity, the tax bill is characterized as a capital gain. As such, the resulting tax bill would be approximately cut in half if, for instance, one were to sell an in the money PPN a week before its scheduled maturity date.
What We Might Reasonably Expect
These are still early days, but, having established what I have been doing and why I have been doing it, the obvious question readers will be asking themselves is, “well, how have his clients done?” Glad you asked. For the ELGIC that matured in September of 2014, the annualized 3.5 year return was about 2.6%. Ironically, the primary product that my clients sold in order to buy the ELGIC also returned 2.6% over that timeframe, so it was a statistical tie. In terms of investment experience, my clients were neither better off nor worse off in that instance.
Given that this is a sample size of one, it is doubtful that we could have learned anything of consequence from this experience, anyway. However, I would like to point out a few things in my defence. First off, the ELGIC option was recommended because I was genuinely fearful of the consequences of a rate hike (or four). The story would likely have been quite different had there been even one hike along the way. Second – and many people forget this – the Canadian stock market dropped by about 20% in the summer of 2011 (mere months after clients bought their ELGIC). Investors got their 2.6% annualized return in spite of a significant market drawdown. Again, had the drawdown been less severe or had it not happened, the score would not have been a statistical tie.
Going forward, all ELGICs sold after the spring of 2011 are currently comfortably “in the black” – in spite of the pullback that started in late July of this year. Obviously, that can change, but I know that my clients will ultimately get their money back, no matter what. I might add that, had my clients stayed in their traditional income products, it is unlikely that they would be able to make a similar claim over a similar time horizon if we experience one or more rate hikes.
It should be noted that my IPSs also assume an equity return of 6% real (above inflation), which, at 2% inflation, is the same as an 8% nominal return. Some people have said “aha!” – if stocks earn 6% real and pay a 4% dividend in the process, then you should be assuming only a 2% real return on an ELGIC that uses those parameters. These people are forgetting a crucial point. That 6% real return includes all years – good and bad. Specifically, it includes the approximately 30% of all calendar years when markets experience a negative return. I don’t know what a reasonable return expectation would be for stock markets where negative years are not counted, but I would have to believe that it is reasonable to expect that average to improve by at least 1.5%. Obviously, I don’t have a crystal ball – and even reasonable expectations sometimes don’t pan out over the span of a decade or so of 12 or 13 overlapping segments of 4 years or so. That said, I believe my projection to be reasonable. In a best case scenario, one might beat the implicit alternative by 5% or more. In a worst case scenario, an investor would still preserve principal, but lag the risk-free alternative by about 200 bps.
In terms of next steps, my guess is that I will continue to recommend ELGICs until we see at least 100 bps (and more likely 150 bps) in rate hikes. To my mind and on a balance of probabilities basis, using a ladder of ELGICs is better than using a ladder of standard bonds or GICs and significantly better than using standard bond funds or ETFs. The experience of the 1940s and 1950s shows us that a prolonged bond bear is certainly possible. Seeing as we are coming off a more than 30-year bond bull, my sense is that such an outcome is (dare I say it) probable. All things considered, I think a ladder of Equity-Linked GICs makes a great deal of sense for conservative people who need income, but don’t want to settle for the paltry 2% that’s on offer right now.
John J. De Goey, CFP, CIM, FELLOW OF FPSC is a Vice President and Portfolio Manager at BBSL. The views expressed are not necessarily shared by BBSL. www.johndegoey.com