By Michael Woods, CFP, CIM
Joan and Joe love to spend time travelling and camping in their motorhome. Being retired they are on a fixed budget with their income coming from government pensions, some retirement savings and a portfolio of fixed income securities (mainly invested in Guaranteed Investment Certificates (GICs)) and a few corporate and government bonds. The problem Joan and Joe face is low interest rates are putting stress on their standard of living as the lower rates have resulted in less income from their investments. Recently, they have had to dip into their principal, which they are not comfortable doing. They would like increased income from their investments but are not sure how to achieve that goal.
Adding equity investments to their investment portfolio would be the easiest way to increase their cash flow. Numerous blue chip equity investments in both Canada and the United States offer yields between 2.5 and 5.0%, with many of these having a long history of increasing their dividend payments on an annual basis (even throughout the 2009 financial crisis). The annual dividend increases result in higher income payments for the investor, ensuring that their cash flow meets or exceeds the rise in inflation. Allocating a portion of their investment portfolio to equity investments will also allow Joan and Joe to benefit from potential capital gains, as the value of their investments grow over time. Joan and Joe will also realize further financial benefits, as Canadian dividends and capital gains receive preferential tax treatment.
If Joan and Joe are unwilling to take on the risk of equity investments, they could ladder their fixed income investments. Laddered portfolios can hold any type of fixed income investment (mutual funds and most exchange traded funds (ETFs) are excluded) and for Joan and Joe’s situation we will focus on GICs and corporate bonds.
This process involves investing in GICs and corporate bonds, which mature at regularly, spaced intervals, as opposed to rolling over one year GICs annually. Not only does laddering allow you to diversify your fixed income portfolio, it is also a simple, yet effective method of returning principal on a periodic basis for reinvestment and one which, over time, produces acceptable returns with lower risk.
The intervals in a laddered portfolio are typically one year apart with a final maturity date of 10 years. The intervals may be arranged so that there are maturities every six months, for enhanced flexibility, and the final maturity can also be shortened.
For example, assuming an investment amount of $100,000 and a final maturity date of 10 years with annual maturities, Joan and Joe could purchase $10,000 of GICs and corporate bonds per year, maturing in consecutive years (from one to ten). When the first $10,000 investment matures in a year, Joan and Joe could reinvest the proceeds in another ten-year investment, as the previous ten-year investment is now nine years from maturity.
There are two other risks that laddered fixed income portfolios also reduce – maturity, or reinvestment risk and inflation risk. Maturity or reinvestment risk is the potential for interest rates to change while holding a fixed income security. If rates drop over the period you hold your investment you may have to reinvest your principal at a lower rate but all the bonds in the portfolio appreciate in value. The opposite is that if rates rise, you will be able to reinvest the maturing bond or GIC at a higher yield. With a steady progression of maturities, such as those found in a laddered portfolio, investors avoid the risk of being concentrated in any one maturity date.
Inflation risk is the risk that your investment returns will not keep pace with inflation, so that a dollar you invest today does not have the same buying power in the future. For example, Joe can buy a can of Coke today for $1.00, but he decides to invest that $1.00 for three years, in the hope that he will be able to buy that same can of Coke in three years, and receive change back. However, when Joe’s investment matures in three years, if he receives proceeds of $1.06, versus the value of the same can of Coke of $1.10, he has fallen victim to inflation risk. Laddered portfolios are a tool to mitigate this risk, as the scheduled maturities allow investors to reinvest in higher returning term deposits, as interest rates rise alongside inflation.
Adopting a laddered strategy for their fixed income investments will allow Joe and Joan to continue to maintain their current standard of living due to higher returns. It will also provide them with peace of mind, knowing their investments continue to be secure. If Joan and Joe are willing to accept some volatility in their portfolio, adding equity investments may result in better returns and cash flow over multiple business cycles, and a combination of a laddered strategy and investing in equities would be the preferred choice.
Michael Woods is a Portfolio Manager with Odlum Brown Limited
The information contained herein is for general information purposes only and is not intended to provide financial, legal, accounting or tax advice and should not be relied upon in that regard. Many factors unknown to Odlum Brown Limited may affect the applicability of any matter discussed herein to your particular circumstances. You should consult directly with your financial advisor before acting on any matter discussed herein. Individual situations may vary. Member-Canadian Investor Protection Fund.