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Author: jesting2 Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 63935  
Subject: Portfolio Diversifiction Date: 12/16/2012 4:41 PM
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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 *
Manulife
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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Author: tengen Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63132 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/17/2012 3:25 PM
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I have my lazy eye on the life insurance companies. They're going through some hard times in this low interest rate environment. Rates can't stay this low forever, can they? I figure buying a lifeco would also offer a nice counter balance to my bond holdings. If rates go up, my bonds will lose value but I'd expect the lifeco to gain value.

PS: Just checked the charts for MFC, GWO, and SLF. Seems I might be slightly late to the party but I feel there will be some fresh doses of bad news that will provide better entry points in the new year.

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Author: tim443 Big funky green star, 20000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63133 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/17/2012 4:18 PM
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Rates can't stay this low forever, can they?


Good question, many are starting to wonder.

Tim

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Author: IKan Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63136 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/17/2012 6:31 PM
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Rates can't stay this low forever, can they?


Good question, many are starting to wonder.




Not FOREVER!
Well I don't think so but I will be dead and gone before then.

In the mean time, yes they can stay down for a few more years. Consider that not much has changed in the world since March 2009. The U.S. is still in denial and broke, and has been for about 20 + years. Greece, Spain and others are still in big doodoo and Japan is not doing great, just to name a few that are in the news almost every day presently.

Historically, these cycles last approximately 20 years. So rates will rise, before FOREVER, as part of the natural/normal cycle. It is not different this time. Humans are still involved!

IKan

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Author: RMarkic Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63137 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/17/2012 8:03 PM
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Hey Tengen

We own them all, so I follow them somewhat.
If you are looking for dividend increases, I would pick GWO, as it is currently at about 56% payout ratio and likely the first one to get below 50% and likely increase the divy.

If you are looking for shorter-ish term price increase, I would pick SLF as it seems to have completed it’s “adjustment” period, and 4th Q earnings ending Dec 31, will replace last year’s Q4 of .90 EPS loss. They will likely report a profit this Q. So if the market is perfectly efficient, this is already priced into the shares but if not…should get a bump in price.

If you are looking for long term price appreciation and dividend increases, I think MFC has the greatest potential. MFC price dropped the most post 2008 fiasco, they cut the dividend, and subsequently adjusted its business risks/exposures, basically hedging out of its past hedged positions, to a more conservative portfolio with less downside, but unfortunately less upside as well. It has the largest footprint in Asia Pac and I think will do well.
The respective dividends GWO, SLF and MFC are currently 5.19%, 5.46% and 4.00%.

If you believe the world is going to end shortly, or over the next few years, I suggest you not buy them. ;-)

At present, I plan to hold them all for the long term and continue to collect growing dividend cheques.

Rick (Yield Hog)

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Author: tengen Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63145 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/18/2012 1:31 PM
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Concerning bonds, I would be very careful about buying them outside a tax sheltered investment account. Most investment grade bonds are trading well above par these days. This means you will have a guaranteed capital loss when they mature.

Another issue with bonds for small investors is that the fees involved in buying/selling them are much higher than for stocks. It's hard to say exactly how much they are as the fees are hidden in the bid/ask prices. This is one area where a full service broker might actually get you a better deal than an online discount brokerage.

Between being taxed and paying high fees, you might be better off buying GICs for investment terms of 1-4 years. Having said that, I believe a well balanced portfolio should have some high quality, longer duration corporate bonds.

PS: The above applies to Canadian residents and Canadian brokerages. I'm not sure how things work for our southern neighbours.

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Author: IKan Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63146 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/18/2012 6:57 PM
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Having said that, I believe a well balanced portfolio should have some high quality, longer duration corporate bonds.



I could not disagree more, in this environment, from the perspective of buying new bonds now.

IKan

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Author: IKan Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63147 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/18/2012 7:00 PM
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Insurance companies make most of their money from bonds so until interest rates rise the insurance companies will not rise in value much as they will not be able to generate increased incomes.

IKan

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Author: RMarkic Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63149 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/18/2012 9:13 PM
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Insurance companies make most of their money from bonds so until interest rates rise the insurance companies will not rise in value much as they will not be able to generate increased incomes

That's a sound bite.

Actually, all this insurance company dead money has moved up pretty nicely already. Since beginning of the year, price appreciation as follows:

GWO +17.6%, SLF + 38.62%, MFC 23.78. Then add in the dividends.

And,I think they are still "relatively" cheap. You can wait till interest rates rise and they get better returns on their float/investments but, the market will reflect that in higher prices.

I certainly can't pick those perfect moments, and I tend to be too early, but even now, I still see lots of upside here. There business is not "normalized" yet, but it will be. Right now between 4% to 5.5% dividend, while you wait for "more" price appreciation.

You pay your money and take your chances.

Rick (keeping it simple)

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Author: tengen Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63150 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/18/2012 11:26 PM
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Insurance companies make most of their money from bonds so until interest rates rise the insurance companies will not rise in value much as they will not be able to generate increased incomes.

Here's a thought: how about doing a pair trade on lifecos and bonds? If one goes down, the other goes up. In the meantime you collect the dividends/interest payments.

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Author: IKan Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63152 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/19/2012 9:29 AM
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Rick,

This might appear conflicting with what I posted but I also agree with your thoughts.

I just wish I could see ahead to know if a 2nd significant market(s) drop will occur. If it did occur I am ready to pounce.

IKan

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Author: ByrneShill Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 63156 of 63935
Subject: Re: Portfolio Diversifiction Date: 12/19/2012 2:10 PM
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I would go with REITs + insurances. One gets hit if rates go up, the other rises with rates.

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