How to invest for income

Although I have written on this topic before, I continue to receive questions from readers asking how to put together a well-balanced income portfolio. How much should be in income trusts, how much in bonds, etc.? With all the options now available, it’s easy to understand the confusion. So let me try to provide some help.

You have to start by deciding three key points. First, how much cash flow do you want from your portfolio? Second, how much risk are you prepared to accept to obtain that cash flow? (Remember the old rule of thumb that the higher the yield on any security, the greater the risk.) Finally, you must determine how taxes will impact your returns.

If the income portfolio is within a registered plan, this point can be disregarded. But if your account is non-registered and therefore exposed to full taxation, it becomes an important consideration.

Once you have made decisions on these three points, the process of selecting specific securities begins. Here’s a quick overview of your choices, in ascending order of risk.

Cash-type securities. This group includes high-interest savings accounts, Canada Savings andremium Bonds, GICs and term deposits, Treasury bills, money market mutual funds, and the like. Usually, these securities pay the lowest returns, however their safety factor is very high. They are best suited for very conservative investors who see preservation of capital as their number one priority. There are no tax advantages here since interest income is taxed at your marginal rate.

Short-term bonds, mortgage-backed securities, mortgage funds. These are only slightly more risky than the cash group. They may suffer small short-term losses in market value when interest raise rise, but on the whole this category is a safe place for your money. Yields tend to be slightly higher than those of cash-type securities. No tax advantages.

Mid-term bonds and bond funds. Yields are higher, but so is interest rate risk. Sudden sharp rises in rates will depress market values, at least temporarily. As a general rule, the higher the quality of the bond, the greater the interest rate risk. Conversely, credit risk is much lower. Again, no tax advantages.

Preferred shares. Preferred shares issued by companies with high credit ratings, like the major banks, are low risk, but not risk-free. For example, preferred share holders of Royal Trust were clobbered several years ago when the company unexpectedly imploded, catching everyone by surprise. The lower the quality rating of the preferred, the greater the risk and the higher the yield. Payments are eligible for the dividend tax credit.

Long-term bonds. Even though they may come from AAA issuers like the Government of Canada, long-term bonds (more than 10 years to maturity) are highly sensitive to interest rate movements, up or down. If you don’t intend to hold a bond to maturity, you need to be very careful in the current environment. Mutual funds that specialize in these bonds pose the same risk. The exception can be real return bonds, because higher interest rates typically go hand-in-hand with rising inflation. As with all bonds, the interest income is fully taxable. However, long-term bonds offer good capital gains potential when rates are falling so keep that in mind for the future.

Balanced income funds. This is a relatively new breed of income-oriented fund. The portfolio typically consists of a mix of different types of income securities, including bonds, income trusts, mortgage-backed securities, common stocks, and preferred shares. Distributions are paid monthly and may have some tax advantages depending on the portfolio composition. If you plan to invest in one of these funds, check the asset mix before you buy. The greater the income trust and high-yield bond content, the more risk the portfolio will carry.

Income trusts and funds. The yields are much higher, but so is the risk. However, as we have explained many times in this newsletter, some income trusts are much riskier than others. The lower-risk trusts are those based on a stable business with a long history of steady cash flow and modest growth potential. The higher-risk trusts are those which are most interest-sensitive and those which are heavily influenced by movements in commodity prices, such as the energy trusts.

Income trust portfolios, such as you’ll find in mutual funds and exchange-traded funds, take this into account when selecting securities and look for an appropriate balance. Some income trusts offer excellent tax advantages while others have most or all of their distributions taxed as if it were interest income. If you are investing in a non-registered account, pay close attention to the tax implications of your trusts.

Next page: Foreign bonds and more

Common stocks and dividend funds. Some stocks offer very attractive dividend yields, which are eligible for the dividend tax credit. But even though they tend to be at the lower end of the equity risk scale, they are still stocks and are vulnerable to broad market movements and to interest rate hikes. Dividend funds are a dog’s breakfast and you need to be very careful. Some dividend funds are really only blue-chip stock funds in disguise, with low distributions and higher risk. A small minority are true dividend funds, with a large percentage of preferred shares in the portfolio and monthly distributions.

Foreign bonds and funds.  Some people like to include foreign bond funds in their portfolio mix for greater diversification. The risk here is two-fold. First, there is the usual interest rate sensitivity associated with bonds. But even more important is currency risk. Bond funds that were heavily weighted towards the U.S. dollar were battered when the loonie rose sharply last year. However, those with heavy investments in Canadian dollar and euro bonds did well. At this time, I don’t feel the reward potential is worth the risk.

High-yield bonds and funds. Let’s not mince words here. We’re talking about junk bonds, those with a low credit rating but high yields. It’s the old risk-reward equation at work again. High-yield bonds are very volatile, but their volatility depends more on general economic conditions than on interest rate movements. When recession threatens, high-yield bonds tend to get clobbered because investors fear the issuing companies may go under or default on interest payments. Conversely, when the economy is in a turnaround mode, this type of bond performs very well, producing good yields plus capital gains. If you want to invest in the tricky high-yield bond market, I recommend doing so through a well-managed fund.

So those are the options if you want to build a portfolio that is 100% income-oriented. Now, how do you put it all together? Here are my income asset allocation recommendations for both registered and non-registered portfolios. I show three investment styles: low risk, medium risk, and higher risk. For most investors, the low risk and medium risk approaches are most suitable at this time. Note that in the non-registered portfolios I have increased the weighting of the tax-advantaged securities.

REGISTERED PORTFOLIOS

Type of Security Cash-type Short-term bonds, etc. Mid-term bonds and funds Long-term bonds and funds Balanced income funds Income trusts and funds Common stocks and dividend funds High-yield bonds and funds

Low Risk 30% 30% 20% 0% 15% 5% 0% 0%

Medium Risk 15% 20% 20% 0% 20% 15% 5% 5%

Higher Risk 5% 10% 10% 5% 25% 25% 10% 10%

NON-REGISTERED PORTFOLIOS

Type of Security Cash-type Short-term bonds, etc. Mid-term bonds and funds Preferred shares Long-term bonds and funds Balanced income funds Income trusts and funds Common stocks and dividend funds High-yield bonds and funds

Low Risk 20% 25% 20% 10% 0% 15% 10% 0% 0%

Medium Risk 10% 15% 15% 10% 0% 15% 20% 10% 5%

Higher Risk 0% 10% 10% 5% 5% 25% 25% 10% 10%