Managing income

These are wild times on the Toronto Stock Exchange. We’ve seen huge price swings both up and down, leaving investors dizzy and wondering where we go next.

Conservative investors and those who rely on their portfolios for income are especially nervous. So let’s take a closer look at how the securities they are most likely to own have performed during this period.

The income trusts sector has been running slightly ahead of the broad index. As of the end of July, the S&P/TSX Capped Income Trust Index was showing a year-to-date gain of 5.7 per cent compared to 5 per cent for the Composite Index. However, those numbers are a little misleading. Income trusts have been lagging behind the TSX for most of the year; it was only a late July surge that pushed them ahead.

Looking at two key components within the income trust sector, we find that energy trusts fared better than the more stable REITs. The S&P/TSX Capped Energy Trust Index was up 12.2 per cent for 2006 but the Capped REIT Index gained only 4.5 per cent for the year. Those numbers clearly show the fundamental difference between the two categories – energy trusts ar virtually immune to the effect of interest rate movements, reacting instead to the ups and downs of crude and natural gas prices. REITs, on the other hand, have been held back by a combination of rising rates and weakening real estate prices internationally.

These numbers serve to re-emphasize the importance of diversity in an income-oriented portfolio. Trusts and the funds that invest in them should be a key part of any such portfolio but adding bonds or bond/mortgage funds to the mix will reduce overall portfolio volatility as will GICs and high-quality preferred shares. The yields will be lower but you’ll experience greater price stability.

In a recent issue of my Income Investor newsletter, I updated two sample income portfolios, one for registered plans and one for non-registered accounts. I divided each portfolio into three sub-groups based on risk levels. Here are my current model income portfolio recommendations. Compare the percentages to your personal portfolio and see where you fit – and whether that’s where you want to be.

REGISTERED INCOME PORTFOLIO
Security Low-Risk Mid-Risk Higher-Risk
Cash-type 20% 15% 10%
Mortgage-backed securities 15% 10% 5%
GICs 20% 10% 10%
Short-term bonds/funds 20%10% 10%
Mid-term bonds 15% 10% 10%
High-yield bonds/funds 0% 15% 10%
Preferred shares 0% 0% 0%
Diversified income funds 10% 15% 15%
Income trust funds 0% 15% 15%
Selected income trusts 0% 0% 15%
Common stocks 0% 0% 0%

Comments: I have increased the cash positions in the mid- and higher-risk portfolios since rising interest rates are producing better returns. I do not recommend any preferred shares or common stocks for registered portfolios because of the loss of the dividend tax credit within an RRSP or RRIF.

NON-REGISTERED INCOME PORTFOLIO
Security Low-Risk Mid-Risk Higher-Risk
Cash-type 20% 10% 5%
Mortgage-backed securities 10% 5% 5%
GICs 15% 10% 5%
Short-term bonds/funds 15% 10% 5%
Mid-term bonds 10% 10% 5%
High-yield bonds/funds 0% 10% 10%
Preferred shares 20% 15% 10%
Diversified income funds 10% 15% 15%
Income trust funds 0% 15% 15%
Selected income trusts 0% 0% 15%
Common stocks 0% 0% 10%

Comments: This portfolio is structured so as to reduce tax exposure by increasing the weightings of tax-advantaged securities like preferred shares, dividend-paying common stocks, and some income trusts. The greater the risk you are prepared to assume, the more tax-efficient the portfolio will be. However, volatility will also be higher.

Conclusion: If you want to reduce volatility, choose the low-risk or mid-risk options. They offer a higher weighting in cash, mortgages, and bonds but you will sacrifice some yield. Investing is always a risk/reward trade-off so you need to decide which balance is appropriate for you. Talk to a financial advisor before taking action.

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