[Eric]

It is my first post in this forum. Sorry if this questions has been asked before, I couldn't find a current answer.

I am at a loss to balance my portfolio with the present extremely low rates and expected high inflation. I am 66 year old with a pension that I can live on (unless inflation kills it) and a substantial portfolio. Usually, I have kept my portfolio 40% bonds and 60% stock. My portfolio is now back at the pre-crash, September 2008 level.

With the expected inflation, I have sold all my bond ETF's and I am left with 15% long term bonds (mostly BCE, bought very cheap), 8% high yield bond funds (Chou and AGF) and 12% cash.

I would like to have more protection against the possibility of another crash without overexposure in case of high inflation. I have started to buy some real return bonds (XRB) but I am concerned that they did fall 20% last October - I don't understand why and it isn't much protection against a crash.

The best I could find for my cash is a 1% Smart Savings Account. I feel excessively exposed if there is another crash. Any advice would be appreciated.

 

[Sampson]

Without an ability to predict how drastic things will change, I would suggest you consider just holding on cash now when rates are low - and waiting for a year or two if possible to see how things play out.

It would be a shame to lock your money in to some low yield bonds, then get hit hard if inflation becomes really bad.

 

[leslie]

I don't agree to RRbond purchases now. Look at the historical graphs. The yield on RRbond is now 1.65%. That is right down at the lowest historical value. An upside move in yields is more likely than an further downside. Yields up = prices down.

Their price fell during the crash because the market say a long-term depression with deflation (reverse of inflation). You don't buy fire insurance during a flood.

Personally I do not see inflation in the cards in the forseeable future so I am not positioning my portfolio to hedge it.

But that said, your comment that you can live off your (fixed I presume) pension worries me. Unless you are sick you may well live 30 years. Inflation most definitely WILL erode that even if the inflation is only 2%. You should not be spending all of it now, but rather reinvesting some to counter that erosion.

 

[Robillard]

I agree with leslie with regards to the inflation outlook. I consider the likelihood of severe inflation in the short to medium term as low. Money supply growth in Canada and the US is relatively slow because many banks are being slow to extend new loans and sitting on their capital. (Even though the Canadian M1 narrow money supply expanded by 15.4% in the year to August 31, 2009, the broad M2 or M3 money supply expanded by only 2% in that same time period.) Please remember that most Canadian dollars are not created by the Bank of Canada, but by the commercial banks.

In the medium term, the likelihood of high inflation is low because of the large amount of slack (unemployment and capital operating far below capacity) in the economy. Until unemployment approaches the "natural" unemployment rate, wage and salary demands are likely to remain subdued, meaning that the probability of an inflationary wage-price spiral is low.

As for why XRB declined 20% last October, I would note a few things. XRB has a high duration since its holdings are long-term government bonds; thus it is highly sensitive to changes in long term interest rates. Real return bonds only provide protection against inflation, not a massive yield spike caused by investors dumping their holdings for US t-bills. There is no real protection against a market crash other than holding cash. Cash earns you little, if anything at all. Also, I wouldn't really try to guess when a crash is going to happen. Consider last fall. Economists and analysts who should have had some idea what would happen in the event of the collapse of Lehman Brothers were caught flat-footed.

 

[Eric]

Thank you Leslie and Sampson for your reply. The RRBond graph is very useful.

I was under the impression that when inflation would rise the yield of RRBonds would be automatically adjusted to the inflation so that their value would not go down the way regular bonds would go down. Am I missing something? I have now 1% of my portfolio in RRBonds, since I do not understand them well, I will not buy more.

Yes, my pension is fixed but it is 20% more than what I spend now and I have an RRSP that I will be forced to liquidate gradually in a few years - its income will equal my pension. I think that will be enough if I live for 30 years with a sustained inflation of 4% - both being pessimistic assumptions.

I also have the rest of my portfolio that I do want to manage responsibly so that I could survive a much higher inflation and, mostly, I would like to leave as much as possible to my children. This is why, despite the crash of last year, I do not follow the rule of having 65% of bonds in my portfolio, particularly given the current yield of bonds.

I am more scared of a sustained high inflation than I am of a stock crash, which explain the present balance of my portfolio. However, I would like to reduce my exposure to a stock crash but I can't find the right vehicle.

 

[Berubeland]

You might consider a rental property. If you properly pick it, it could insulate you against inflation, provide possible appreciation, and diversify your portfolio.

This is not an option to consider lightly but it is an option.

 

[el oro]

Robillard - The gurus I agree with expect an inflation that does not require unemployment to decrease.

OP - Gold and other physical assets and related investments will do well during inflation. During the crash, physical gold was one of the best performing assets. Even though the spot price went from $1000 to $700 per oz., apparently you couldn't buy an oz. for less than $850 or more as premiums and demand skyrocketed. The quoted spot price isn't the whole story.

 

[Eric]

Thank you Robillard. I do not understand the Mx criteria, but it is good to see some experts more optimistic about inflation than the news media. From a layman perspective, I think that the US will not manage to reign in their deficit. I am still assuming that we are in a bond bubble.

I have been studying the RRBond yield graphs that Leslie had referred to. I have tried to relate them to the price of XRB and I am more puzzled then ever. I like the fact that the XRB price went up 10% in the first 9 months of 2008 while the stock market was declining.

Berubeland, as a question of life style, I would not want to have direct rental properties. Do you have any opinion on real-estate ETF's?

Actually, I am well protected (may be too much) against inflation. More than 40% of my portfolio is in commodities now (including the XIU component). Sorry '$1600 Gold by 2011', I think gold will loose its strength as a standard. I prefer copper (FM); it is more useful. In the last 3 months, for instance, FM has appreciated much more than XGD - China needs copper not gold.

I have 15% in non-hedged International (Claymore ETF's). I think that the US $ will sink and that the Canadian $ will go higher than parity but still move down relative to International currencies.

I am coming to the sad conclusion that the only way to protect against a crash, without loosing too much with inflation, might be to have significant cash, at 1% for now.

Finally, I am looking into International High Yield funds; I do like the AGF fund. Any opinions?

 

[leslie]

To address what I consider some of your misperceptions:

"When inflation would rise the yield of RRBonds would be automatically adjusted to the inflation." When the Consumer Price Index rises, the Face Value of the bonds rises equally, and the the coupon$ payment rises as well. But that bigger coupon remains the same percentage of the now larger face value. So the coupon RATE does not change with inflation.

Of course there are market actions that change the 'yield to maturity' that is what is graphed on the BkOfCda site. The value of the security is impacted by BOTH these factors - the inflation impact on the face value and the market impact on yields.

The best (and only) place to explain how they work is at Shakespear's:
http://www.bylo.org/rrbs.html
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"The XRB price went up 10% in the first 9 months of 2008 while the stock market was declining." You should not presume from that the two securities are negatively correlated, or that RRbonds provide protection from stock crashes.

At the start of the year RRbond prices reflected a 2.75% yield. If you look at the graphs (the 3rd proved the closeup view) you see that yield was the highest in a long time. (High yield = low price). Since then it has fallen to 1.65% yield. That is a difference of 1.1 percentage points. Since RRbond have a high duration (say 15) you would expect a 15% rise in security value from the change in yield PLUS the negative 1% due to the negative CPI.
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The comment on real-estate is a good one. It has the attributes of covering half of your living expenses (rent) from before-tax income , growing both the rent coverage and asset value by inflation (over the long run), and being a store of value to either leave to heirs or pay for long-term care.

The problem is that for single people at lower tax rates, those attributes lose a lot of their ooomph. And RE securities are not a substitue. And RE does not protect from inflation over short periods. See the graphs at the bottom of this page.

 

[Eric]

Thank you Leslie. You are a mine of information.

Yes, speaking of face value and payments for RRBonds, rather than yield, makes then more understandable. I will read the references you indicated.

 

[Berubeland]

I don't have any particular opinion on real estate ETF's

I would say because I work in the business that there is a bit of a shakeup in the commercial sector. I see a lot of vacancy in my travels out and about.

Residential is pretty hot so steady returns for the next while. Wait for the shake up and buy low in commercial.

Thats my 2 cents