With interest rates at historical lows, many investors are looking for innovative ways to increase the returns they are receiving on the fixed income portion of their portfolios. Here are a few ways an investor can increase returns, while understanding the risks of higher yielding securities:
Increasing the Duration of your Portfolio
Basically, increasing duration means purchasing longer term fixed income securities. If the investment is appropriate for your needs, extending term can be one way to obtain a higher return on your fixed income portfolio.
One must be careful with extending the maturities of your fixed income holdings. Fixed income by its very definition provides a fixed stream of income, plus a fixed repayment of your principle at maturity (assuming no default). However, the price of a bond does change from day to day, in conjunction with interest rates. For example, if the prevailing market interest rate is 6%, would you be willing to pay full price for a bond that is yielding 4%? Probably not! This is especially true for longer dated fixed income securities, investors want to be compensated for receiving below market interest rates. So if you are going to be selling this security before maturity, be aware that in times of rising interest rates, your bond’s value will be declining.
The opposite is also true; in times of decreasing interest rates, longer term securities will increase more rapidly in value than short-term securities. However, hoping for capital appreciation on fixed income securities today is very risky, as long-term interest rates are at historical lows. The declining overall bond rates have provided great returns for fixed income investors, ETFs and mutual funds over the past five years; however, this is unlikely to continue indefinitely.
The bottom line when it comes to extending the duration of your portfolio is to only purchase fixed income securities that match your requirements for funds. If you are five years away from retirement and needing access to your funds, holding a portfolio of largely thirty year bonds is probably inappropriate. If you are thirty years away from retirement, having a portion of your fixed income portfolio in long dated bonds is probably an appropriate way to increase your returns.
Increasing the Risk in your Fixed Income Portfolio
Investors can increase returns on their fixed income portfolios by increasing the credit risk in their portfolios. What this means is purchasing more risky securities, which offer higher returns. Don’t let this necessarily scare you at first glance, there are ways to increase returns without taking extraordinary risks. For example, provincial government bonds tends to pay anywhere from 0.10% to 1.00% higher than comparable Government of Canada bonds. Provincial bonds are one good way to increase your returns without taking extraordinary risks. High quality companies such as major Canadian banks, insurance companies and public utilities also offer higher returns than government bonds.
To the extreme, higher risk resource companies and technologies firms must provide very high returns on their debt. But many professional portfolio managers view the risk on these securities as substantial, and classify these investments more similarly to stocks.
It’s important to ensure proper diversification if you intend on pursuing a risk focused strategy. Having all your savings in one corporate name could be very risky if that company runs into trouble. One way to accomplish diversification is to purchase a corporate bond ETF or mutual fund. This allows you to hold numerous corporate bonds, reducing the risk of one individual company running into trouble.
Preferred Shares
For many years, individuals have overlooked preferred shares as a great way to increase returns in their fixed income portfolio. Preferred shares are issued primarily by highly credit worthy companies, like banks or public utilities. Recently, however, more risky firms have become involved in the preferred share market, such as resource companies. These offer substantial returns, but the risk on these securities is very close to that of owning the common equity of the firms. An investor has to be careful of how much risk they are taking on, especially if the intention of the investment is to diversify away from common equity positions.
Generally, preferred shares will offer a higher return than similarly risky corporate debt. This is because in the event of a default, the company must pay debt holders first before preferred shareholders receive any money. Preferred share investors are compensated for this risk through higher returns than what one would receive by investing in comparable debt securities. Preferred shareholders rank ahead of common shareholders, however, so these securities are generally less risky than owning common stock.
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Another advantage of preferred shares is the tax treatment of preferred dividends. While interest from bonds is taxed generally at the highest rate (and this is why most fixed income investments should be held in an RRSP or TFSA), preferred share dividends receive a dividend tax credit, increasing your after-tax return. If you do not have room in your RRSP or TFSA but are looking to purchase a fixed income investment, preferred shares are something that should definitely be considered.
All of these methods are ways of increasing returns in your fixed income portfolio. However, one must understand the risks and ensure that the investments you are purchasing are appropriate for your situation. The fixed income market is less liquid and research is harder to find for individual investors compared to stocks, so getting sound advice if you are uncomfortable is important.
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Why not use banks as a substitute for Buffett’s “dangerous” bonds? Banks handle everyone’s money and make Billions doing it. I think investing in banks as opposed to keeping money in the bank is a better idea.
Hi Stu – Good question, banks can be an attractive dividend that is quite similar to fixed income securities (with some upside). However, do remember that dividends are paid at the discretion of the Board, and there are some additional rules now in place that preclude banks from paying dividends if certain capitalization and liquidity tests are not met. This makes these investments less certain than good quality bonds.
Bank “rate reset” preferred shares are an alternative that gives you some added yield without taking on added maturity risk. Plus the dividends on these shares must be paid out prior to dividends on the common equity, making them more secure.
I don’t disagree with the idea of having some bank stocks in a portfolio, but they are considerably more risky than most fixed income assets. I’ll give you one last example. Royal Bank (RY) is the biggest bank in Canada, and has a Beta of 1.27. This means the stock is actually not only correlated to index returns, but will actually outperform the index in both directions, positively and negatively. The idea of having bonds and other fixed income assets in your portfolio is to reduce the overall variance by having assets that are less correlated to the index than stocks. Bank stocks don’t accomplish this reduction in variance.
I hope that at least provides some food for thought.
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