A fixed-income strategy for tough times

The grinding bear market has prompted many RRSP investors to take a fresh look at the fixed-income side of their portfolio. In many cases, they’ve discovered that they are woefully underweighted in bonds, GICs and the like as a result of the stock market exuberance of the late ’90s. That left them exposed to more risk than they were comfortable with when markets dropped.

The problem with trying to rebuild the income side of an RRSP is low interest rates. They’ve started to rise in Canada, but they are still close to 40-year lows. That means returns on conventional fixed-income securities remain depressed.

So what can you do in these circumstances? Our advice is to give some careful thought to what type of income securities you want to hold in your plan, the level of risk you are prepared to accept, and your anticipated return.

As you do this, remember a cardinal rule of investing: when interest rates fall, bond prices rise and vice versa. That guideline can be extended to all types of interest-sensitive securities, including fixed-rate preferred shares, royalty trusts, and interest-sensitive common stocks like utilities and pipelines.

The rece track record of all these securities looks very good. But the successful investor looks ahead, not back. Rear-view mirror financial management almost always generates below-average returns.

We’ve seen two recent examples of how a turnaround in interest rates has a negative impact on fixed-income securities. In 1999-2000, central banks pushed up interest rates because of concerns about an overheated economy and rising inflation risks. Bond fund valuations were adversely affected. In 1999, the average bond fund lost 2.7 percent of its value. Long-term bond funds fared much worse, however. Altamira Bond Fund dropped 8.4 percent during that period while the Spectrum Long-Term Bond Fund fell 8 percent. By contrast, short-term bond funds fared much better, with the average fund gaining 1.4 percent over the year. The worst loss in the category was less than 1 percent.

Dividend funds were also weak in the rising interest rate environment. The average gain for the category was only 2.4 percent and some funds actually lost ground.

We saw a similar situation in the late winter-early spring of 1994, when rising interest rates also hammered fixed-income funds.

So the danger is very real, and you should be sure the fixed-income component of your RRSP portfolio is ready to deal with it.

The starting point is to review exactly what you’re holding in the way of interest-sensitive securities. In Part 2, to be published next month, we’ll look at several types of fixed-income securities and discuss the characteristics of each.

Adapted from the forthcoming book Gordon Pape’s 2003 Buyer’s Guide to RRSPs, by Gordon Pape and David Tafler. To be published by Viking Canada in fall, 2003.