Market Intelligence

Seeking Yield, Tactically

Monday, October 29, 2012

Seeking Yield, Tactically


By Tyler Simms
Associate Portfolio Manager

In today’s market of low interest rates, how are investors able to generate a dependable income stream without taking on undue levels of risk?

A growing number of investors – particularly those drawing down their retirement savings – rely on their investment portfolio as a source of steady income. In the past, more conventional sources of secure income such as high-quality bonds, money market funds, and GICs have been very eff ective at dampening risk while providing a safe income stream. But in the wake of a prolonged decline in government bond yields, these asset classes appear less appealing and investors are questioning the adequacy of returns, net of taxes and inflation.

A New Reality
Yields on Canadian and U.S. government bonds have continued their downward trend over the past decade with the 10-year Government of Canada bond yield hovering just above 1.8% as seen in Figure 1. The payoffs from other ‘low-risk’ savings vehicles like GICs and money market funds are even more underwhelming. As examples, recent postings for bank-issued GICs quoted interest rates of 1.9% for two years and 2.2% for fi ve years, while returns for money market funds have been largely absorbed by management fees, leaving little for investors. So why the persistent low-rate environment? It is a combination of broad-based accommodative monetary policy by Global Central Banks coupled with increasing risk aversion. " This has driven government bond yields to all-time lows and has dragged the rest of the yield spectrum along with it.

From a portfolio perspective, there is no substitute for the risk mitigation and correlation benefi ts of high quality fi xed income investments. And as long as the threats of recession or defl ation continue to loiter, yields on these assets will continue to remain low. However, these “riskless” bonds now face stronger than ever headwinds, thus the risk-reward benefi ts of owning them may be diminishing. In sum, government yields will eventually normalize, resulting in potential for serious losses for the asset class. Looking forward, the challenge for income investors is clear: how do I generate a reliable yield from my portfolio with below-average risk?

We believe investors would be well served to adopt a tactical and diversified portfolio approach for generating investment income. We provide a review of this income approach along with a brief description of the various asset classes that can be incorporated into this type of portfolio.

A Tactical Approach
Our tactical approach to asset allocation is designed to take advantage of value dislocations across the yield asset spectrum by reallocating capital among asset classes to enhance performance. As history has shown, equities tend to increase in value over the long term, but not during certain intermittent periods, most prominently the past fi ve years. By applying a more dynamic approach to asset allocation, we can combine our best yield ideas across the investment spectrum (described below) while maintaining a steady portfolio income with less than half of the volatility of stocks.

Corporate Bonds & High Yield Debt
As far as saving instruments go, investment grade corporate bonds offer a reasonable combination of yield and principal protection. Although rates are higher than government bonds, they too remain low compared to historical averages. Investors should remain aware that corporate bonds are sensitive to changes in credit worthiness of the underlying companies, in addition to shifts in interest rates. That at being said, with economic pessimism prevailing, corporate bond spreads have been expanding, and we are fi nding more opportunities to add to investment grade issues in this space with yields between 3.0-6.0%. As a subset of corporate bonds, high yield bonds is an asset class that offers relative value, in spite of recent gains, off ering current yields in the 7.0% range. And while risk is markedly higher than investment grade issues, corporate balance sheets are in much better shape than previous pre-crisis levels due to global companies hoarding cash and strengthening their balance sheets. " rough a disciplined research process and proper security selection, we consider corporate bonds – investment grade and high yield – to provide attractive yield characteristics and potential for gains as credit spreads narrow.

Preferred Shares
Preferred shares tend to be less understood by investors, given their hybrid characteristics of being in between common shares and corporate bonds along the risk spectrum. However, when actively managed and properly evaluated, preferred shares can be an attractive alternative for investors seeking yield. This is true particularly when considering on an after-tax basis, given the lower tax rate applied to dividend income. Returns for preferred shares have been lackluster over recent quarters creating opportunities to add quality issues to the portfolio with yields between 4.0-5.0%.

Dividend-Paying Stocks
We believe that investing in a portfolio of high-quality companies, at attractive valuations, and with high dividend yields, plays an important role in a tactical yield strategy. In Canada, the S&P/TSX Composite Index is currently yielding 2.7% while the government 10-year bond yield is at 1.8%. This has created the rare market circumstance where investors can earn higher yields from common share dividends than from long-term government bonds as seen in Figure 2. This phenomenon is not unique to the domestic market, as the United States and major European markets are experiencing this rarity as well. But while dividends are an attractive source of income, they are no substitute for bonds given their greater volatility, and an active risk management approach is highly recommended.

A carefully managed portfolio of dividend paying stocks can add value in a number of respects: it can lead to potential growth in dividend income over time, and even provide a partial hedge against inflation as companies pass along rising prices to consumers. Through our process, we have been able to add new positions in quality names with dividend yields between 3.0-7.0%.

Mortgage Investment Corporation (MIC)
A MIC is an investment that provides exposure to a pool of commercial and residential mortgages; flowing all net profits through to MIC investors. As lenders, MICs have an element of fixed income but these entities trade on the TSX index as equities, sometimes creating misunderstandings. The big advantage of these investment pools is that they provide access to a diversified basket of individual mortgage loans across a number of different borrowers and geographic areas. And the contribution to portfolio yield is healthy – MICs current yields range between 6.0-8.0%.

Emerging Market Debt
Compared with domestic government debt, sovereign bonds issued by Emerging Market countries are an attractive addition to our yield portfolio. While it is true that Emerging Market exposure comes with more geopolitical risk, in many cases the fiscal positions of these countries are healthier than those of developed market economies. From our perspective, this asset class provides access to a larger opportunity set of debt issuers with higher yields than those available in Canada. It also benefi ts diversifi cation because of its low correlations to domestic bonds.

Closed-End Funds (CEF)
Surely one of the lesser-known corners of the yield market is closedend funds. CEFs are similar to the more commonly known ‘openended’ mutual funds but with a few notable differences: CEFs have a fi xed number of shares which trade on an exchange, they can employ leverage, and generally trade at a discount to its underlying net asset value (NAV). This additional complexity brings about opportunities to exploit inefficiencies and we have identified attractively priced CEFs with yields between 6.0-8.0%.

Options Strategies
Stock options – puts and calls – can be useful tools for enhancing yield and risk management processes. In particular, selling call options against individual equity holdings is a low-risk way to generate incremental income in the portfolio. In addition to yield, options can be used to manage volatility by implementing hedges to protect for downside risk. Combined, options act as an effective overlay for a tactical yield portfolio.

Through a broad combination of asset classes discussed above, we can build portfolios with below average volatility and an attractive yield on a tax efficient basis (as shown in the below table).

* assuming an Alberta investor in the highest marginal tax bracket

In what has proven to be a challenging market for yield seekers, investors are straining to fi nd adequate income solutions. To help meet these objectives, we recommend investors employ a tactical approach and allocate capital across a diversified set of asset classes.

If you are interested in further discussing this article, we would be happy to provide you with additional insight at (403) 234-6118.



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