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Take Stock – What to Do About the Brewing Crisis in Your Portfolio

 

Take Stock is the Motley Fool Canada’s free investing newsletter.  To have future editions delivered directly to you, simply click here now

Last week, while attending a Morningstar-hosted conference for financial advisors in Toronto, I was taken aback by advice that is both pervasive and dangerous.

You see, there seems to be a widely held belief among advisors that client portfolios must have some allocation to fixed-income investments (i.e., bonds).

Bonds have enjoyed a massive bull run over the past three decades, so this advice has worked quite well. For instance, the average annual return on a 10-year Treasury since 1980 has been an astounding, virtually risk-free, 9% (compared with 12.5% for the U.S. stock market, as measured by the S&P 500).

Clearly, a portfolio that incorporated stocks and bonds over this period made a pile of sense and produced outstanding risk-adjusted returns.

Those days are gone 

However, based on the sentiments expressed at the Morningstar conference and recent Canadian fund flow data, investors in this country seem to be placing the historically valid theory of diversification over the present-day reality of valuation.

With the 10-year Canadian government bond yield in the low 2% range, bonds are no longer an inexpensive asset class, as they were in 1980 when their yields were in the mid-teens. In fact, they’ve never been more expensive! And the thing with expensive asset classes is that they don’t tend to stay expensive forever. (Click here for my in-depth Fool.ca post on this subject.)

Even worse is that we’re not only ignoring how expensive bonds are, we’re investing in the absolute worst medium for this asset class: bond mutual funds.

The Investment Funds Institute of Canada (IFIC) reported that at the end of April, Canadian bond funds held assets of $143 billion, up a whopping 20.9% over April 2012. Add in another $169 billion or so in fixed-income investments from “balanced” funds (combo stock/bond vehicles), and that’s more than $300 billion of Canadians’ savings tied to what could be the worst-performing asset class of the next decade!

Not good

Warren Buffett was recently quoted as saying that bonds are a “terrible” investment right now. Well, bond-focused mutual funds are even worse. Here are two key reasons:

  • ·         Unlike an actual bond, bond funds don’t mature. Typically, they target a specific duration. To maintain this target, they must constantly buy and sell bonds within the portfolio, realizing gains and losses. In an environment where yields are rising (prices going down), they are more likely to be realizing losses in the years to come.
  • ·         These funds face real redemption concerns. Even if the funds were holding their bonds to maturity, as investors realize that the trend in rates has shifted, they will no doubt begin redeeming their bond fund holdings … and the funds will have to liquidate some holdings to satisfy the redemptions. Again, the funds will incur a capital loss as a result.

What to do

Fear not! There’s a way out of this quagmire, if you’re willing to move beyond the archaic view that, at current levels, bonds offer sound diversification for your portfolio. They did, but they don’t anymore.

The solution? Diversify your equity portfolio with … wait for it … more equities!

As bond yields have ticked higher over the past month or so, we’ve been able to see how this game is going to play out once it really begins in earnest. This is not necessarily today, and not tomorrow, but as Jim O’Neil, former chairman of Goldman Sachs Asset Management says, “Investors should get used to U.S. Treasury yields rising toward 4% as the 30-year bull market in bonds comes to an end.”

How to position yourself

To be clear, rising bond yields provide an indication that the economy has stabilized to the point that it no longer needs the artificial support of government intervention. That’s a decidedly good thing. Cyclical stocks in the energy, materials and industrials sectors are therefore likely to benefit.

With that in mind, among the most direct ways to play the theme of rising bond yields is by investing in Canada’s life insurance companies, including Manulife Financial, Sunlife, and Great-West Life. In addition, the parent companies of Great-West Life, Power Corp., and Power Financial are also likely to benefit. The reasoning is twofold — they’re set to see rising interest incomes and falling liability profiles, with good dividends to boot — click here for a more thorough explanation of why I am bullish on life insurance companies. (Full disclosure, I own shares of Sunlife, which I feel is the cheapest of the Big 3.)

Be wary of

Now, it won’t be all roses in equity-land. You’ll want to steer clear of the sectors known as “interest-sensitives” — namely, REITs, utilities, and telecom stocks. All three have offered top-tier returns in recent years as investors have sought out yield, but if/when rates rise, this tide will quickly turn.

The Foolish Bottom Line

We don’t know if this recent lift in rates is temporary or the start of something much bigger. We do know that over time, rates really only have one direction to go — and we also know that there are approximately $300 billion worth of Canadian investment assets that are ill-prepared for this eventuality. Investing is all about setting yourself up for success. Not all investments pan out, but if you play the odds right, over the long term you’ll come out ahead of the game.

Currently, the odds say, fixed income looks to be a losing bet.

Fools Want to Know

Last week we initiated our “Ask a Fool” service, which allows our fellow Fools to communicate directly with us and send us any burning questions. Unfortunately, we had some technical difficulties with the email address. These have since been sorted out. We apologize if your question was kicked back and encourage you to resubmit.

The address is CanadaEditorial@fool.com.

One Fool broke through these technical difficulties and passed along several questions that primarily relate to our future service offering.

To François, thank you for being a loyal Fool and we are grateful for your patronage to the services offered through Fool.com.

Underlying all Motley Fool services is an emphasis on uncovering attractive risk/reward opportunities. Once we have an advisory service running here in Canada, which can be expected later this year, we will indeed carry through with this focus. As indicated in a previous Take Stock, if a good risk/reward opportunity exists, you’re going to hear about it. The more overlooked and potentially disruptive, the better. An emphasis is likely to be placed on the small- and mid-cap portions of our market as this is where these kinds of opportunity predominantly lie.

François specifically asked if we would be looking for opportunities on the Montreal Exchange. The Montreal Exchange has been converted to a derivatives exchange and no longer provides any kind of equity trading. Out of the gate, and for the foreseeable future, our focus will be on equities and, therefore, we’re unlikely to have much to do with the MX.

And French? Again, out of the gate, it’s likely to be an English-only service, although with time, once we get an idea of demand, we will certainly look into providing a bilingual version of our advisory service. This is a wrinkle that does not exist in the U.S. but is no doubt an important future consideration for our Canadian Fools.

Thanks again François!

Recent Developments

In case you missed it on Fool.ca, please check out Fool.com’s award-winning columnist Morgan Housel’s take on the Canadian housing market. It’s a must-read! Simply click this link

‘Til next time … happy investing and Fool on!

Sincerely,

Iain Butler

Senior Analyst

The Motley Fool Canada

P.S. Attention all investment writers! We’re always looking for new contributors for Fool.ca, so if you’re interested in providing Foolish commentary on Canadian stocks, or if you’ll be in the Toronto area on July 11 and are interested in attending our Blogger Bonanza, send me an email by clicking here. We still have a limited number of seats to fill.

P.S.S. Be sure to follow us on Twitter and Facebook for the latest in Foolish investing.

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