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Sep 1, 2017

Striving For Yield

by Peter McMurtry

Peter McMurtryHow does the retail investor earn a satisfactory investment yield in today’s environment of low, but very gradually rising interest rates?

The U.S. Federal Reserve and more recently, the Bank of Canada have both highlighted the need for rising rates in this period of stronger economic growth.

Historically these central banks have normally waited to raise rates until inflationary pressures were more evident. Low commodity prices combined with technological innovations have kept consumer prices from rising very much. Labour rates also remain relatively low despite the low unemployment rates in the U.S.

The central banks feel they need to raise rates now when economic times are on the uptrend. Keeping rates low for an extended period would provide them with less ammunition to deal with a recession in the future.

Investors, in particular seniors, have been faced with low rates for a very long time but have refused to see their standard of living fall accordingly. Consequently, many of them have taken on much more investment risk than they are comfortable with by replacing low fixed income investments with high dividend paying common stocks. Investing in REIT’s, utilities, telcos and bank stocks have all offered much higher yields than bonds, GICs and savings accounts. In addition, these Canadian dividend stocks are more efficiently taxed with their dividends eligible for the Dividend Tax Credit.

Personally, I am also faced with the same dilemma. My wife and I do not have defined benefit pensions and need to rely on the income from our investments to complement our CPP and OAS income.

Taking into consideration that interest rates need to rise from these low current levels, I have been very reluctant to invest my capital in longer term fixed-income securities that will see declining prices as soon as rates rise. I have chosen to have a higher than average cash content that normally would be invested in fixed income securities.

Rising rates do affect both bonds and stock returns and investors need to be very aware of the potential pitfalls that can result from this scenario. Bond prices always go down when interest rates rise, with longer dated maturities and strip bonds the most negatively affected. High dividend paying stocks tend to also go down when rates rise and the extent of their price decline reflects many factors including their current valuations on a PE basis and the amount of debt they have.

REIT’s, utility and telecommunication stocks all have similar characteristics currently. They are trading at high Price/Earnings (P/E) multiples, are highly leveraged and are largely in slower growth industries where their profits are not rising nearly as fast as other sectors. Their dividend yields are higher than the overall market, but their high dividend payouts and levered balance sheets provide a major obstacle for them to increase their dividends. There are always exceptions to the rule as evidenced by the strong cash flow and dividend growth experienced by Fortis, Emera and Chartwell Retirement Homes. The latter companies’ strong earnings, cash-flow and dividend growth will more than offset the negative effect from rising rates.

On the other hand, Canadian financial stocks also have high dividend yields but differ from the previously mentioned sectors in that they benefit from rising rates and a steepening of the yield curve. Banks earn an interest rate spread from borrowing short term funds and lending these funds out in longer term maturities.

Insurance companies benefit from rising rates in a different way than banks do. The higher interest rates go the lower their long-term liabilities become in present value terms. This ultimately produces a stronger balance sheet that enables these insurance companies to expand their revenues accordingly.

The general consensus is that interest rates will be rising over the next several years. However, it is interesting to note that the yield curve spread between 10 and 2-year Government of Canada bonds has actually narrowed to around 70 basis points from the historical median since 2012 of 95 basis points. The same trend has occurred in the U.S.

Central banks only control short term rates. Investors ultimately determine long term yields which reflect short term rates plus an inflationary premium. Thus, we are currently experiencing short term rates rising faster than long term ones.

While interest rates are expected to rise, the current flattening of the yield curve is not beneficial to the bank’s interest rate margins.

Consequently, there are pros and cons to all types of investments at this time.

I have always believed that total return (income and capital growth) is more important than simply straight income. When rates are low like they are today, it is important not to focus solely on generating an income. What matters to investors is total return in any case, but this does involve more risk taking.

I also do not advise focusing on high dividend paying stocks, preferring to invest in stocks with rising dividends over time. This will ensure that your income is not diluted away by inflation and will provide an offset to the negative effects of rising rates.

Taking all this into consideration, I would structure an income portfolio as follows:

Cash and equivalents    32.5%

Bonds                              10.0%

Preferreds                      10.0%

Common Equity             47.5%

Please keep in mind that I am recommending a much higher cash weight than normal. This cash surplus would normally be invested in fixed income, but the current rates are just too low and not worth the risk.

High-interest savings accounts are currently yielding 1.90% for Alterna Savings and 2.30% for Equitable Bank. Oaken Financial, a subsidiary of Home Capital, offers a one-year GIC rate of 2.75%. Investors need to be cognizant of the fact that CDIC insurance guarantees deposits up to $100,000 including interest. If you have an investment of $100,000 and the financial institution goes under, you will only be reimbursed your initial capital, but no interest. In addition, there would be a time delay before CDIC paid you back your capital.

A short term corporate bond ETF would satisfy the bond component like the iShares 1-5 Year Laddered Corporate Bond Index ETF (CBO).

I do not recommend a junk bond ETF as the risk of default is too high.

Horizons offers an actively managed Canadian preferred ETF, Horizons Active Preferred Share ETF (HPR) with a nice dividend yield of 3.9%. Most of the preferred shares held in this ETF are rate reset ones that benefit from rising rates.

Finally, I recommend a well diversified common equity portfolio that is not focused only on high yielding dividends. Having exposure to all sectors and investing in companies that have rising earnings, cash flows and dividends makes the most sense. Investors cannot rely on dividends from commodity producers as they could be cut at any time. I also advise significant exposure to both the US and international markets for capital growth, even though dividends from these companies are not subject to the Canadian dividend tax credit.


Peter McMurtry

Peter McMurtry, B. Com, CFA

Financial Writer for Do-It-Yourself Investors