[tojo]

A question for those who maintain a balanced portfolio of stocks and fixed income:

There is a strong belief in the investment world that the expected long term returns from equity will be in the order of 8% or perhaps 7%. The returns of fixed income are expected to be in the order of 2 or 3 % less.

I’ve noticed recent new offerings of bonds that are rated BBB (borderline junk I suppose) that maintain 5 to 30 year maturities, paying 7.5% per annum or more.

I would be very happy to collect 7% over the next 10 / 15 years, as this will more than meet my investment objectives, because when all is said and done, this is what matters the most – that we don’t take on more risk than required and that we properly manage portfolio risk.

Would it be prudent to overweight a portfolio with such fixed income products, as a diverse basket of such bonds? Won’t this still be safer than equity and meet return objectives?

Note: can assume that reinvestment of returns can go into safe fixed income, say 5 year Provincial bonds. Thanks in advance….

 

[FeeOnly.ca]

IMHO reconsider

"A question for those who maintain a balanced portfolio of stocks and fixed income:

There is a strong belief in the investment world that the expected long term returns from equity will be in the order of 8% or perhaps 7%. The returns of fixed income are expected to be in the order of 2 or 3 % less."​

Typical investment planning strategies assume one “average” growth rate over the accumulation period and sometimes a slightly lower "average" during retirement period. As a result many advisers and clients mistakenly think that an individual investor is likely to experience “returns” consistent with long term historic "averages".

Unfortunately it won’t turn out that way (darn that “reality” thingy). Actual results will in fact vary widely. Sometimes it will be much higher but of greater concern are outcomes that are much lower than the "averages".

Jim Otar has gone to great lengths (using actual historic data) to clearly illustrate the potential damage a secular market trend can do to an "average" return forcast. Especially with a distribution portfolio.

Learn from... but don't expect to earn ... "average returns".

Graham

 

[tojo]

"A question for those who maintain a balanced portfolio of stocks and fixed income:

There is a strong belief in the investment world that the expected long term returns from equity will be in the order of 8% or perhaps 7%. The returns of fixed income are expected to be in the order of 2 or 3 % less."​

Unfortunately it won’t turn out that way (darn that “reality” thingy). Actual results will in fact vary widely. Sometimes it will be much higher but of greater concern are outcomes that are much lower than the "averages".

Jim Otar has gone to great lengths (using actual historic data) to clearly illustrate the potential damage a secular market trend can do to an "average" return forcast. Especially with a distribution portfolio.

Learn from... but don't expect to earn ... "average returns".

Graham

I think you've just reinforced my point, particularly with equities...there are no guarantees, and I've seen many portfolios and plans destroyed from market crashes going back from the 80's to now. I have done an assessment of my situation, and know I can do well with a 5 - 7% return over the next 10 years. Still, I've chosen a fairly large component in equities in my portfolio despite the fact that there are products out there that can provide my target yields at much safer options. Perhaps it is just time for me to re-allocate and take the "safer" route. Thanks.

 

[Robillard]

Tojo,
You have to remember that the yield-to-maturity on bonds is based on the the unlikely assumption that all coupon payments can be reinvested at the same interest rate. On long term bonds, the yield on reinvested coupons (where ever you reinvest them) can make up most of the most of the return on your investment.

For example, if you invest $100 in a 30-year, $100 face value bond that pays an 8% yield, but you simply deposit the coupons in your chequing account, at maturity you will get back the face value of the bond ($100) and you will have earned $240 in coupons that didn't compound at all. Over the 10 year period, you would have only earned a 4.16% return on investment (CAGR), and not the 8% as was advertised on the bond. Incidentally, if you could reinvest all the coupons at 8%, you would have approximately $1006.27 in 30 years, and not $340. Therein lies the power of compound interest.

The real problem with most bonds it the reinvestment risk. By comparison, stocks have a much larger variance of returns, but reinvestment risk is often not an issue. Stocks that pay no dividends are expected to provide a return based upon capital appreciation or start paying dividends eventually. Stocks that pay dividends can in some cases let you reinvest the dividends through a DRIP.

That being said, I agree with the general sentiment that I can't see why one would want to buy a stock when an investment grade bond is offering a comparable long-term yield with much less variance of returns (ignoring reinvestment risk and the effects of inflation).When you do consider reinvestment risk and inflation though, stocks start to look like a decent proposition.

 

[furgy]

Tojo,


For example, if you invest $100 in a 30-year, $100 face value bond that pays an 8% yield, but you simply deposit the coupons in your chequing account, at maturity you will get back the face value of the bond ($100) and you will have earned $240 in coupons that didn't compound at all. Over the 10 year period, you would have only earned a 4.16% return on investment (CAGR), and not the 8% as was advertised on the bond. Incidentally, if you could reinvest all the coupons at 8%, you would have approximately $1006.27 in 30 years, and not $340. Therein lies the power of compound interest.


.

Robillard , thanks for the great post , I just learned a little more about bonds , something I've never really invested in personally because I don't completely understand them.
Every little bit helps.

 

[tojo]

Tojo,
The real problem with most bonds it the reinvestment risk. By comparison, stocks have a much larger variance of returns, but reinvestment risk is often not an issue.

Thanks Robillard...

It's this reinvestment risk that has bothered me as I get more into fixed income. I face the same challenge when dealing with prefs, as the dividends are not reinvested, and DRIPs are not an option. Yield-to-worst calculations I do show nice annualized yields, but it's not CAGR or compounded - but merely annualized % of the "face" amount ... and the longer the duration, the more I get hurt if I don't put the returns back to work.

At the very least, this mental exercise highlight the fact that one must properly tailor his / her portfolio to their own needs and risk tolerance. Thanks again...

 

[Robillard]

Tojo,

You can buy bonds that have no reinvestment risk. They are typically referred to as zero-coupon bonds or strip bonds (strips for short). Strips are basically normal bonds that have had their coupon payments removed by the investment dealer. They eliminate the reinvestment risk becaus there are no payments to reinvest. When you buy a strip, if you hold to maturity (and the issuer does not default) you will earn the yield-to-maturity of the bond when you purchased it. Of course, you can also sell prior to maturity, but strips have a peculiar tax treatment. The gain an investor makes on strips, as time goes by, is taxable as interest income, and not as a capital gain. (I think it's a bit more complex than this, but this is the simplified explanation.)

There are some downsides to strips. Firstly, the market for strips is typically less liquid than the market for the underlying bonds, so the spreads are wider. The second is that strips can be much more sensitive to changes in interest rates. A bond that has coupons spreads out its payments over time, and is less sensitive to changes in rates that affect the payment at maturity. And of course, as with all bonds, credit risk is a concern. If you are earning a regular stream of coupons, you can invest those coupons elsewhere where they are not exposed to the credit risk of the issuer. By comparison, with strips, if the issuer defaults, you can say goodbye to the payment of the face value at maturity. (As with other debt instruments, strip bond holders fare better than preferred shareholders or common shareholders in the event bankruptcy.)

There are some corporate strips out there, but there appear to be many more government strips on the market. Several months ago, I saw some Bell Canada strip bonds trading on my discount broker's bond trading page. If you are really interested in corporate strips, you should call your broker's bond trading desk (the brokers' webpages only show a fraction of what is out there).

 

[CanadianCapitalist]

This is a great discussion. My 2 cents:

My fixed income portion at 20% is strictly to lower the volatility of the portfolio. I avoid long-term govt. bonds and corporate bonds in my fixed income portion. The excess return from long-term govt bonds does not justify the interest rate risk. Corporates have their own set of issues, most important of which is the higher correlation with stocks. Therefore, I'd rather take the risk of stocks instead of long-term bonds. Corporate bonds due to their high correlation with equities are not desirable.

This is not to say you can't make money with either asset class. Just that I prefer stocks to both.

 

[tojo]

Tojo,
You can buy bonds that have no reinvestment risk. They are typically referred to as zero-coupon bonds or strip bonds (strips for short). Strips are basically normal bonds that have had their coupon payments removed by the investment dealer. .

That's a great idea Robillard....I can diversify strips with conventional bonds such that if rates rise, I can put the returns from regular bonds to work into those with higher coupons rates. Thanks.