Why bonds are risky right now for your portfolio

Tara Perkins
Globe and Mail Update
Published Friday, Feb. 24, 2012 6:00AM EST
Last updated Friday, Feb. 24, 2012 6:41AM EST

With a greater concern for preserving their wealth rather than building more, high-net-worth individuals confronting volatility tend to look for lower-risk investments. But the Catch-22 these days is that traditionally lower-risk vehicles may present higher risk in the long run.

One way to deal with volatility is to find an equities comfort zone, experts say. That way investors can take some risk off the table at peaks and add some in valleys.

The first step is determining your financial goals. Second, create a basic plan with a financial adviser that has flexibility built into it for those moments when you are feeling a bit more positive or, conversely, a bit more risk averse.

Laura Wallace, vice-president and portfolio manager in Bank of Nova Scotia’s private client group, tells clients to figure out what rough mix of stocks and bonds is likely to meet their needs over the long run, and then establish a range of exposures to equities.

“It might be a 40- to 60-per-cent equity range, for example,” she says. “What we find is that making a pre-established range when times are calm allows you to make the right decision when times are crazy.”

Ideally, you would be at the bottom end of the range and buying stocks at a time like the fall of 2008, when markets imploded. And you would be at the top end of the range and selling stocks during a euphoric period, such as the peak of the Internet bubble in 2000.

What about right now? Ms. Wallace suggests being at the mid-point of your range.

This is due to two factors, she explains. Due to low interest rates, fixed income securities are offering only tiny returns at best, especially once you factor in taxes and inflation. Also, stocks may be cheap, but most experts don’t expect them to rise in the near term.

“We think there’s going to be a fair amount of volatility over the next six months or so, and so the combination of those two things leaves us in the mid-point of our asset range mixes,” Ms. Wallace says.

In other words, since bonds are offering pitiful returns, they are actually a risk to a portfolio.

“I see 10-year treasuries, even Government of Canada bonds, as being one of the riskiest asset classes over the next 12 to 24 months,” says Scott Hall, a vice-president and portfolio manager at Canaccord Financial.

Even a whiff of higher interest rates could push bond returns broadly into negative territory.

But with markets up and down, potential economic crises and slow growth expected for the while, stocks are also risky.

Stocks will continue to be a risk for the next three to 10 years as the global debt super cycle works its way through the financial system, predicts Paul Taylor, chief investment officer at BMO Harris Private Banking.

“Because we accumulated too much debt, economic growth rates are going to be more modest for an extended period of time,” he says. “And therefore earnings in the stock market are going to be tight. Equity markets are just not going to be on this massive upward swing that we’ve been accustomed to in the past.”

And if a default of Greece or another European country sparks a liquidity crisis, all bets are off.

Still, many advisers lean to equities for the long haul, though they differ in their strategies. “Longer term, now probably more so than ever, equities offer better relative value than fixed income vehicles,” says BMO’s Mr. Taylor.

If volatility doesn’t scare you, you might want to kick it up a notch. Why own bonds that yield 2.5 per cent when you can own shares of BCE that yield more than 5 per cent? “If you can wait out the volatility, you’re going to be better off in the BCE stock,” says Scotiabank’s Ms. Wallace.

On the other hand, “with the markets having just rallied 23, 24 per cent off of the October lows, our advice at this point is to probably be looking to take some risk off the table and adopting a slightly more defensive posture, not putting new money to work,” says Canaccord’s Mr. Hall. “If anything, right now we are raising cash. Our expectation is that the markets will in all likelihood pull back, maybe as much as 5 to 10 per cent, after this 20- to 25-per-cent rally. At which point in time we would then look to deploy our cash.”

Mr. Taylor suggests, “Assemble a portfolio of very high-quality securities, some Government of Canada’s, some quality provincials, some blue chip corporate bonds. Hold some convertible debentures, hold some relatively juicy preferred shares, and hold some straight common shares in absolutely blue chip franchises.”

Ms. Wallace adds that she likes natural resources and Canadian financial institutions right now. Mr. Hall says that commodity trading accounts and managed future accounts are good ways to increase your return profile without excessive risk. He is a fan of emerging markets, particularly Brazil, and for high-net-worth clients with an appetite for some risk, he is making use of private equity investments, including smaller oil and gas firms.

Perkins, Tara. “The Globe and Mail.” Home. The Globe and Mail, 24 Feb. 2012. Web. 01 Mar. 2012.

Investors seeking a steady yield, yet fear the bursting of the bond bubble, may want to plug into utility shares.

The Utilities Select Sector SPDR, which represents the 34 utilities in the S&P 500, has risen 2.5% this year, trailing the broader index’s 9.3% gain. Still, most of the S&P 500’s increase has come in the past two months as cheap money from the Federal Reserve has spurred investors to snap up riskier assets, leaving boring utilities stocks behind.

On the other side of the ledger, bond buyers who would potentially be attracted to utilities yields — the Utilities Select Sector SPDR yields 4% compared with a 2.6% payout for the 10-year Treasury — have been hesitant to leave the supposed safety of government securities for equities even after an unprecedented run-up in bond prices.

Additionally, energy costs will remain high for the foreseeable future, which will translate into higher revenue as most public utilities operate as regulated monopolies.

In these turbulent times characterized by very low interest rates, utilities offer a portfolio the anchor of downside protection coupled with dividend yields that are very competitive with fixed income securities.”

“The United States must move to rein in its massive budget deficits or it faces the risk of a bond market crisis” according to former Federal Reserve Chairman Alan Greenspan .

He spoke as a panel, chaired by former White House chief of staff Erskine Bowles and former Senator Alan Simpson, is due to deliver a report on debt and deficits by December 1.

Greenspan believe that the deficit, which is set to hit $1.3 trillion this year, may begin to frighten the bond market, which could undermine the recovery and push the economy back into recession. “The only question is, is it before or after a bond market crisis? Because there’s no alternative,” he said.

“The big, serious problem is whether or not the outlook for the longer-term deficit spooks the bond market to a point where long-term interest and mortgage rates move up very sharply,” said Greenspan. “If that happens, that will cause the double dip.”

A draft report made public last week offered a series of politically tough tax and spending choices that would seek to reduce the debt by $4 trillion by 2020.

Long-only portfolio managers traditionally manage risk through asset allocation strategies that concentrate on finding a balance between equity, fixed income, and cash. Portfolio managers wanting to minimize volatility generally do so by increasing exposure to fixed income products while simultaneously underweighting equities.

But what happens when demand for seemingly safe fixed income investments, such as government and investment grade bonds, drives prices up to ‘bubble’ territory. Shifting assets out of equities and into an inflated asset class such as bonds does little to minimize risk.

Here, long-only portfolio managers are handcuffed – constrained by the fact that the fixed income alternative is in fact no alternative at all. That leaves cash as the only substitute for equities. Of course, cash tends to be dead weight. And while there may be times that sitting on cash makes sense, investors simply do not need to pay professional money managers to hold onto cash.

This is where option licensed portfolio managers outperform their long-only counterparts – not only in higher returns but in managing the overall risk profile of the investment portfolio. Suitably designed options strategies can add considerable value to a tactical asset allocation program.

Rather than change asset allocations in order to modify risk profiles, option licensed portfolio managers can use puts and calls to preserve capital, enhance income, and reduce market volatility without having to sell equities outright.

Many unsophisticated investors see derivatives and options as instruments used to increase, rather than to reduce risk. Nothing could be further from the truth. Investors interested in prudent risk management strategies should be looking at option instruments including puts and calls.

Buying plain vanilla puts are similar to buying portfolio insurance and protect investors against a market fall. These type of instruments are great for conservative investors who want capital preservation. Not only do puts provide a floor in the event that the market falls, but they allow investors to enjoy all the benefits of a rising market as well as any dividend payouts. In this environment, where fixed income instruments are overpriced and bond yields offer next to nothing, maintaining equity exposures with put protection is the way to go.

In addition to buying puts, income oriented investors can also consider option strategies including covered calls and collars. These strategies are a tad more complicated than simply buying puts. That said, they are not beyond the reach of ordinary investors who have been brainwashed to think that risk profiles are based on asset allocation.

Make no mistake, there’s a real bond bubble forming and unfortunately many conservative investors are on the verge of a rude awakening. Whereas the stock market crash of 2007 punished greedy, risk seeking investors, this time around it will be conservative, risk-averse investors who take the hit. Protect your portfolio with options.

Jeff Kaminker
Frontwater Capital