Building an income portfolio

Income investors have two strikes against them these days. Strike one is low interest rates which have driven down yields on GICs and government bonds to levels where they barely manage to keep up with inflation, currently running at 1.3 per cent.

Strike two is the run-up in market price of former income trusts, which has driven down yields considerably. If you own them, at least you have some nice capital gains to compensate for the yield drop. But those who missed out have been left scrambling to find good securities with decent cash flow.

That said, it is still possible to construct a decent income portfolio. I recommend that you approach it on a segment-by-segment basis, starting with the lowest-risk securities.

Begin with your fixed-income choices. The older you are or the more risk-averse your temperament, the greater the percentage of fixed-income assets you should hold. Studies have repeatedly shown that the higher the fixed-income weighting in a portfolio, the less vulnerable it will be to loss in a down market.

With yields on government issues at near record lows, investment grade corporate bonds are the best choice. However, buying bonds at retail is not always easy for ordinary investors. Discount brokerage firms usually have small inventories. You’ll do better at large, full service brokers but even they may not offer the specific bond you’re looking for at the yield you see quoted on the Internet or in the business pages. Shopping around is difficult if you don’t have accounts at several firms.

Here’s a tip that may help. Ask your broker to alert you to high-quality new issues that become available. Companies are always raising capital and some of the new issues I have seen recently look very attractive in the context of the current interest rate environment. Discount brokers may not have much to offer but a good full-service broker should let you know when attractive issues come out.

If buying individual bonds doesn’t work for you, the iShares DEX All Corporate Bond Index Fund (TSX: XCB) is a good alternative. We originally recommended this ETF in the Income Investor newsletter in January 2009 when it was trading at $18.77. It closed on Aug. 24 at $21.32 and pays monthly distributions of about $0.07 per unit. Based on the current price, the projected yield over the next 12 months is 3.9 per cent.

For those who prefer mutual funds, the Bissett Corporate Bond Fund is a good choice. It invests in a portfolio of high-quality bonds mainly from Canadian issuers such as Royal Bank, Manulife Financial, and Bell Aliant. It’s not the top performer in its category by any means although the three-year average annual compound rate of return is a very respectable 5.9 per cent. The trade-off, and it is an important one for income investors, is low risk. The worst 12-month period in this fund’s history was a loss of 3 per cent in the year ending Oct. 31, 2008. That was a much better result than most other corporate and high-yield bond funds, some of which suffered declines in the high teens during that time. The fund pays monthly distributions of $0.035 per unit which projects to a yield of 4.16 per cent at the recent net asset value of $10.10.

Once you have resolved the fixed-income side of your portfolio, then what? The obvious answer is the stock market. Fortunately, you have a wide range of securities from which to choose, depending on your risk tolerance.

If you’re a conservative investor who puts a premium on capital preservation, highly-rated preferred shares are the logical place to start. They are not risk-free but they are less volatile than common stock. The new Series BB from Canadian Utilities (TSX: CU.PR.E), which we recently recommended in The Income Investor, is a good choice.

Next up on the risk scale are the high-yielding blue chip stocks and there are a number of them from which to choose. Some that we currently like are TransCanada Corp. (TSX, NYSE: TRP) which yields 3.85 per cent, Bank of Nova Scotia (TSX, NYSE: BNS) with a 4.24 per cent yield, and Power Financial (TSX: PWF) at 5.63 per cent.

Conservative investors will probably want to stop here. The risk curve begins to rise from this point. If you are willing to live with that, the next level up would include securities such as Brookfield Renewable Energy Partners (TSX: BEP.UN) which yields 4.68 per cent, Inter Pipeline Fund (TSX: IPL.UN) at 4.97 per cent, Pembina Pipeline (TSX: PPL) which pays 6.15, and REITs.

At the higher end of the risk scale, look at securities such as Ag Growth International (TSX: AFN) which pays $0.20 a month to yield 7.25 per cent, Chemtrade Logistics Income Fund (TSX: CHE.UN) which yields 7.5 per cent, and Bonavista Energy (TSX: BNP) at 8.28 per cent.

The bottom line is that even with low interest rates it is still possible to build an income portfolio that will provide decent cash flow at reasonable risk. So don’t get discouraged. Two strikes is not out! Ask a financial advisor if any of these securities are suitable for your account.

Photo © Dennis Owusu-Ansah

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