How To Balance Risk And Reward

If you are looking to make off-farm investments in stocks or bonds, you’ll find you’re stuck between a rock and a hard place. The rock is the wavering returns of the stock market, now in a sideways pattern and liable to plunge if the world economy goes into the double dip contraction that many analysts fear. The S&P/TSX average hovers around 11,500 as I write this column. That’s where it was in October 2009. The rock is the incredibly low returns of government bonds, hardly enough to make it worthwhile to buy the bonds in the first place. Bank accounts mostly pay less than one per cent; money market funds much less after the banks and other vendors deduct their fees. What’s an investor to do?

It is a question of objectives. If you want your money in a year or less, the bank is still the best deal going. Beyond a year, if you don’t want to take a chance of loss, there is not much for the ordinary investor. A few corporate bond exchange traded funds offer alternatives, as do some preferred stocks. ETFs are priced and traded on the TSX and other stock exchanges. You can find their content, fees, distributions, etc. on websites. And they offer the small investor a great deal of diversification, all for fees a tenth or even less of those of mutual funds.

ETFS AND PREFERRED SHARES

The best bond ETF going for yield and safety is the Claymore one to five year Laddered Corporate Bond ETF, symbol CBO on the TSX. It has a current yield of about five per cent, distributes interest monthly and is relatively stable. This is not a recommendation, of course, just an illustration of what can be had from a diversified and relatively safe portfolio of corporate bonds with a short-term bias. The portfolio’s credit risk is limited and rate risk — what happens if interest rates rise — is also constrained. All in all, it’s a conservative way to beat miserable returns at your local financial institution.

Preferred shares are riskier than bonds, because their dividends, which must be paid before common shareholders get theirs, are only issued at the pleasure of the directors of the company. Nevertheless, there are many preferreds issued by chartered banks, virtually none of which are likely to be subject to skip their dividends in the foreseeable future.

Examples are abundant — Royal Bank Preferred E, recently priced at $20.42, has yield of 5.6 per cent, is a perpetual, that pays $1.13 per year with a Feb. 24, 2012 call the bank can make to cancel the issue and pay holders $26 per share and for three years thereafter with prices falling by 25 cents a year to 2016. Perpetuals are not for everybody, for if interest rates rise a great deal, the issuer would probably leave the shares in place. Only if rates fall a good deal, which is not likely given the low range of current rates, would Royal Bank be likely to call the shares. The low share price and yield pretty well express the risks and returns of the issue. But the issue’s security is not in doubt — it is Royal Bank, after all, and the return, boosted by a roughly 28 per cent kick from the dividend tax credit in upper tax brackets, is valuable. The payout is equal to that of a fully taxed 7.17 per cent bond-interest payment.

WHICH TO BUY?

Predicting interest rates over periods of a few years to 20 or 30 years is very difficult. Ten years ago, the collapse of the global economy in 2008-09, worldwide bank crises and the global plummet in interest rates was on almost nobody’s mind. That bond interest rates would hit 15 per cent in 1982 would have been unbelievable in 1960 when most government bonds paid about four per cent per year.

Interest rate risk affects every bond, every preferred and, for that matter, every stock with a yield over four per cent. Add in the credit risk that companies can and do fail — think of once-mighty Nortel Networks or investment bank Lehman Bros., and the risk of fraud (remember Enron?) and you can see the risks intrinsic in moving out of low-yield government bonds into corporate bonds and preferred shares.

The question of whether to buy corporate bonds or preferred shares as an alternative to government bonds or money market funds or bank accounts that pay close to nothing is really what you get for taking on risk. If you want to go shopping, check out preferred issues from Brookfield Asset Management, Power Corp. and even Manulife.

These venerable companies have retractables that eliminate the problem of the perpetual — being stuck with them forever. The issuer can call the issues back at designated times. Some of these shares are less than top preferreds one and some of the companies are not fond of shareholders, at least to judge by how they slash common dividends. But cuts to preferred dividends would put these companies in a corporate doghouse from which they would not emerge for years. Their costs of raising capital would soar, and the reputations of management would be tested. Are cuts possible? Of course, but you have to look at the politics of capital markets too.

So is it worth shopping for corporate bonds and preferreds? I’d say it is, provided that you get a complete market list and go over it with great care. You can shop for corporate and government bonds at www.pfin.ca.

You can also throw fixed-income caution to the wind and buy common stocks with strong and rising dividends. Chartered banks pay four to five per cent and utilities five to six per cent. Some industrials such as BCE Inc., recently priced at $32.16 have a hefty 5.6 per cent yield, for example.

In the end, crummy returns at the bank need not be an end to the income one can get from financial assets. Good stocks, good corporate bonds and many fine preferreds are being traded at relatively low prices in a market still spooked by the disaster of the 2008-09 meltdown and the prospects that the world could melt down once more.

It is reasonable to think that good yields on senior companies’ common and preferred shares and bonds do pay for the risks you take by leaving government bonds and insured bank accounts. The trick in going into any of these markets is to diversify either through use of exchange traded funds that specialize in high dividend common — so-called “dividend aristocrat” funds, preferreds or laddered bonds like the Claymore example. Invest slowly, do your research and diversify. The key question is not whether there is money to be made, but whether you are paid enough for the risks you take.

AndrewAllentuck’slatestbook,WhenCanI Retire?PlanningYourFinancialLifeAfterWork, waspublishedbyVikingCanadain2009.

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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