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Greetings All,

One of the basic tenants of portfolio management is that to manage risk, a portfolio should be adequately diversified. Diversification itself is a matter of some theoretical discussion. There is the obvious equity/fixed income balance question, complicated by the decisions to be addressed relative to the age of the investor. Then there is diversification within the equity and fixed income components themselves. Domestic, foreign, large/small cap, government, corporate and so forth.

It is not my intention to get into a detailed dissertation about general diversification. I have my personal opinions about diversification and perhaps I will visit other aspects of this issue in the future. Today, I will make the assumption that everyone should have a portion of their portfolio in fixed income and look at a couple of issues we should consider when selecting products for this portion of our investments.

Fixed income refers to bonds and debentures but often investors include GICs, certificates of deposit, and treasury bills. These last three investments provide a guaranteed (or virtually guaranteed) return of your original investment so are the least risky of the fixed income class. The safety of funds also means that their yields will be the lowest available. They are generally short-term investments and the shorter the term the lower the risk, which also results in lower yields. And yields are important. You may get your capital back safely, but if you are depending upon income from your portfolio, you need the best yield you can find. Today, 1yr-5yr GICs have yields from 1.75% to 2.45%. 1yr – 5yr GoC bonds yield (Yield to maturity is a combination of coupon payment and capital gain or loss) .78% to 1.57% and 1yr – 5yr Corporate bonds are yielding 1.04% to 2.36%. Increasing the term will increase the risk and the yield. Today 10yr GoC bonds yield 1.59% to 2.42% while Corporate bonds will yield 2.20% to 4.94%. The longer term instruments add a degree of credit risk, but often ignored, they add interest rate risk. Especially so today when rates are at historical lows and are expected to increase in the next five years. For example, if interest rates go up 1%, todays’ ten year GoC bond with a yield of say 1.8% would likely see a price drop of around 8%. That loss will be permanent unless rates drop again.

Also affecting yields is the credit worthiness of the issuer. Governments are generally seen as being the most creditworthy but there are obviously exceptions. Greece, Italy and Spain whose Debt/GDP ratios are 131.5%, 117.3% and 48.3% come readily to mind based on news stories coming out of the E.C.U. But the U.S.A. is running at 76.8%, 60% higher than Spain. Canada’s ratio is 52.6% looks better until you compare it to Australia’s 29.5% ratio. Corporate issuers generally have lower credit ratings and must pay more so yield will be higher.

So as we look for higher yield, we must weigh the risk of time and creditworthiness.

Another risk that must be considered is the risk of inflation.

In his Dec/12 article in “Investment Executive”, Michael Narine of Tacita Capital in Toronto quotes a report by Credit Suisse in the Global Investments Yearbook, stating “Canadaian long-term government bonds have provided investors with an annual real return of 2.2% since 1900”. The same report indicates that globally, the real return was 1.7% for the same period. (The real return is the net yield from the bond less the inflation rate.) In recent years, especially for the period leading up to and through 2008, bond investors have seen excellent returns on their investments. Partially due to the falling interest rates which have caused bond prices to rise and long-term bonds still hold these capital gains. As time passes, these bonds will return to par so returns will see a steady decline. If interest rates increase, these declines will accelerate.

In the same article, Narine writes, “Investors seem to require about a 2% annual real return for incurring the risks inherent in long-term government bonds.” Statistics Canada reports that the October/12 rate of inflation was 1.2%. That means that investors need 3.2% to achieve a real return of 2%. Looking at the rates for 10yr GoCs averging 2%, they will not meet the target real return. Even the average corporate rate of 3.57% will only provide a real return of 2.37%. Anyone going that route should expect a real return at least 2% higher than what can be achieved with GoCs to compensate for the additional risk.

What is of concern here is that equity funds are in net redemption almost every month while bond funds enjoy capital inflows. This is a clear indication that investors are still afraid of the market and they see safety in bonds backed up by historical returns.

It is important to establish a fixed income limit for your portfolio and stick to it. Bonds have done well recently but the returns will start to decline going forward. I believe that what we can see from bond going forward is the coupon rate less the capital loss as they approach maturity, assuming they are purchased at a premium. And virtually everything available to purchase in a ten year term is selling at a premium today.

If you find yourself with too much in the fixed income side of your portfolio, consider purchasing some large cap blue chips that are paying good dividends. Favour companies that grow their dividends regularly, have steady earnings growth and have lower percentage of earnings payouts. It is quite easy to put together a group of stocks that will produce a dividend yield of between 5 and 6%. Certainly there are risks, but weighed against the bond risks, the added returns may make the risk acceptable.

Here are a few ideas but not necessarily recommendations as I have not reviewed them all:

Any of the big six banks *
BCE Inc *
TransCanada Corp *
Husky Energy
Great West Lifeco *
Crescent Point Energy *
Enbridge Inc *
Sun Life Financial
Rogers Communication Class B
Barrick Gold
Suncor Energy
Canadian Oil Sands Ltd
Cenovus Energy
Canadian National Railway
Encana Corp
IGM Financial*
Telus *

(*) Indicates I hold these companies either directly or their parents or subsidiaries.
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