Make money in a weak market

The last few years have been tough on investors. Stocks have experienced the most prolonged bear market we’ve seen since the mid-’70s. On the other hand, low interest rates have made traditional safe havens, such as GICs and T-bills, unattractive. People have been scrambling to find alternatives that won’t put their life savings at risk.

Retirees and those who are coming up to retirement are especially frustrated. Putting together a low-risk, high-income portfolio is a real challenge, one which some financial advisers are having trouble meeting.

It can be done, however. It just takes some imagination and ingenuity.

Let’s look at the key components of an income-oriented portfolio.

• Guaranteed investment certificates (GICs).  These were the bedrock of retirement accounts for many years, and they still have a place. They’re issued by financial institutions and are covered by deposit insurance up to $60,000 (sometimes more if they are issued by credit unions, depending on the province). That makes them safe and dependable. The problem is that five-year returns have been less than five per nt for some time. It’s not likely to move much higher any time soon unless the North American economy suddenly goes on a tear.
  Conclusion: safe but unattractive from a yield perspective.
• Mortgage-backed securities (MBS).  These represent shares in pools of residential first mortgages. They are fully guaranteed for both interest and principal, without limit, by Canada Mortgage and Housing Corporation (CMHC). That means they’re backed by the federal government. Income is paid monthly and represents a combination of interest and return of principal. But as with GICs, the returns are unexciting, almost the same as the average GIC. The CMHC also issues bonds of its own, with similar yields.
  Conclusion: safe but low return.
• Bonds.  There are all types of government and corporate bonds available, but if you want higher yields, you will have to accept more risk. Returns are driven by two factors: maturity date and credit rating. The longer the period to maturity, the higher the yield. However, if interest rates rise, your bond will decline in value. Bonds with the highest credit rating are those issued or guaranteed by the Canadian government, so they pay the lowest return. If you come across corporate bonds with what appear to be astonishingly high yields, beware: it usually means the company is in financial trouble, and default is seen as a real possibility. You can find information on credit ratings at Standard and Poor’s Canadian website: www.standardandpoors.com/canada.
  Conclusion: useful but you must choose carefully.

Next page: Bond funds

Bond mutual funds.  Some people prefer to buy bonds directly rather than pay a commission and management fee to invest in a bond fund. This could be penny wise and pound foolish. You do pay a commission when you buy a bond through a broker. However, it doesn’t show up on the transaction statement, so ask before you buy. You may be shocked at how much it is. Second, a bond fund gives you portfolio diversification and access to the manager’s expertise. Unless you’re an expert bond-picker, that may be well worth the expense. If you need regular cash flow, ask how often distributions are made before you invest.
Conclusion: a useful choice, and for some people, a bond fund may be preferable to direct bond investing. 

Preferred shares.  Preferreds are especially useful for non-registered portfolios, but the whole field is a dog’s breakfast. The credit rating of the issuer is critical and here again you can find information on the Standard and Poor’s website. But there are many other considerations as well. For example, some preferreds can be called in before their maturity date at a fixed price (some bonds also are subject to early redemption). Some preferreds pay a fixed dividend; others use a floating rate that is tied to prime. Some are denominated in U.S. dollars. Some are “non-cumulative,” which means if the issuer defaults on a payment, it won’t be made up later. If you want to own preferreds, make sure you have a top-notch financial adviser. Otherwise, choose a dividend income mutual fund that holds a high percentage of preferreds in its portfolio. Many don’t, so check carefully.
Conclusion: useful but very tricky. Can be higher risk.

Income trusts.  There are several kinds of income trusts, and it’s important to understand the distinctions between them. I break them down into three categories, as follows:

 1) Industry income trusts. These specialize in a specific area of the economy, such as the energy sector or real estate (in the latter case, they are known as REITs). The trust holds assets, such as oil wells or shopping malls, which generate cash flow. Most of the profits (usually 80 to 90 per cent) are distributed to unitholders on a monthly or quarterly basis. However, the distributions are not guaranteed and will be significantly affected by such factors as the world price of oil.
 2) Corporate income trusts. These operate on the same principle, but the underlying asset is a single business — a mattress factory, a cold storage company, A&W burger outlets, etc. If the core business is doing well, unitholders receive generous distributions. If it does poorly, they may get nothing — there have been cases in which trusts have suspended distributions because there were no profits to pay out.
 3) Portfolio income trusts. In this case, the trust invests in a portfolio of securities, usually common or preferred shares. The managers employ sophisticated techniques to generate income. Some of these trusts guarantee to return your capital after so many years. However, that guarantee comes with a price. To achieve it, the trust invests a significant portion of its assets (sometimes more than 50 per cent) in a strip bond that matures on the date the trust is wound up. This greatly reduces the cash available to invest in the securities that are supposed to produce the projected income. Earlier this year, many unitholders in such trusts were shocked to learn that their distributions were being cut when falling stock prices threatened to erode the capital base to an unacceptable degree. The guarantees are still in place, but if investors bail out now, they’ll take a big loss. They have to hold until maturity to get their capital back.

Next page: Significant risk still involved — what to consider

Clearly, there is significant risk involved in income trusts. But with interest rates still low, they remain enticing. If you want to add some to your portfolio, here are some tips.

• Understand the risk. These are not government bonds. Distributions may seem high now, but they are not guaranteed. Nor is your principal, except in the case I’ve just described.
• Look at the track record. Some trusts have been around for several years. See how they’ve done in good times and bad
• Avoid new issues. They’re very difficult to assess. Some will do well, but others won’t. Go with the known quantities.

Conclusion: income trusts can substantially boost income returns, but you must choose carefully and be prepared to accept more risk.

Income trusts mutual funds.  Instead of trying to pick the best income trusts, you may prefer to let a money manager do that for you. There are several mutual funds that specialize in income trusts. They enable you to spread your risk while handing the responsibility for selection to a professional manager. Some have been in business for several years and have a good track record. I especially recommend Guardian Monthly High Income Fund, Saxon High Income Fund, Renaissance Canadian Income Trust and Bissett Income Fund. Most of these funds pay monthly distributions, which is great if you need steady income. Some of the payment will be tax-advantaged or tax-deferred if the units are held outside a registered plan.

There are also some funds that trade on the stock market, such as Citadel Diversified Investment Trust (TSX:CTD.UN). These operate in a similar manner to mutual funds, in that they invest in a portfolio of various types of income trusts. However, they can only be bought and sold through a broker on the Toronto Stock Exchange, and their market price may be somewhat less than their current net asset value.
Conclusion: very useful for steady income and higher yields. But remember, there are no guarantees.

The best approach for an income investor at this time is to use several different types of securities. Choose GICs, mortgage-backed securities and government bonds to provide portfolio stability. Then, add some corporate bonds and selected income trusts or funds to increase your overall returns. The result will be a portfolio that should generate cash flow in the six to seven per cent range, while keeping your overall risk to an acceptable level.

That’s a formula that looks pretty attractive as we progress through 2003.