November 2023 Newsletter
The answer is unfortunately “not really or not yet?”. I historically am not a big fan of fixed income mostly because it would likely lower my returns in the long run. I do understand that the credit market (fixed income) is a big deal and there is certainly a place for it. In the small investor world, fixed income is fine for short term needs i.e. you will be buying a car in the next year or two and you will need cash. Before we go too far, lets discuss what fixed income is to the small investor.
Fixed income 101
Fixed income conceptually is simple, lend someone your money and they promise to pay you back all your capital sometimes in the future, with interest. You will find fixed income in many forms but they are all basically the same. Most people are familiar with lending their money to their bank, known as Term Deposits or Guaranteed Investment Certificates (GICs). Also popular, are Treasury Bills (short term) and Treasury Bonds (long term) which are basically loaning your money to the government. You can also loan your money to other organizations such as municipalities or corporations aka municipal bonds and corporate bonds respectively. You can even invest in Exchange Traded Funds (ETFs) based on certain types of Bonds to make it even easier.
Once the borrower is established, then one only has to choose the duration of the term which can vary from a few months to over 30 years. Returns are based on prevailing interest rates as well as time and risk. Generally higher risk and longer durations pay better returns. The government Treasury Bill or Bond for instance is considered risk free because of the reliability of the government. A bond issued by Bell Canada or Verizon will have a higher yield than a government bond simply because they are more risky.
There Are Risks!
Default is the biggest risk which is well understood. A more subtle risk which most people are less aware of is the relationship fixed income has with interest rates. Its an inverse relationship, rates go up, and investments like bonds go down, or vice versa. Only when you hold a 5% bond all the way to maturity, lets say for 20 years, will you return exactly its promised 5% yield. However as rates rise and fall over those 20 years, the value of the bond will also rise and fall quite substantially. The market for fixed income is derived from the supply and demand of existing and newly minted bonds. Example, If interest rates go up and newly minted treasury bonds pay more than the one you originally bought, supply and demand will force your bond to lower in price. Its the only way that your bond can stay competitive in the market. Why would I want to buy your bond paying 3% when I can buy the same exact bond paying 5%. But if you lower your price down enough so that the resulting return is the same, then were good…you get the idea. The rise and fall in bond value is much greater on longer duration bonds and much weaker on short duration. Big swings in interest rates can be very destructive to bond holders or alternatively provide a big payout, all depending on the direction of rates. This effect is also seen in rate sensitive investments like utility stocks, Real estate Investment Trusts (Reits) and big non growing dividend payers.
Another risk people do not often realize is that fixed income generally under perform stocks most of the time (using rolling 20 year averages). For the few times that fixed income outperform stocks, its not by allot. This is important because even slight differences in returns over very long periods say 20-40 years will have huge impacts on the amount of money you retire with. Retiring poor is a real thing, a risk.
Is inflation a risk?
Inflation is another factor that wrecks havoc on fixed income. Don’t get me wrong, it affects all asset classes, its always and everywhere like gravity. The problem for fixed income is that as mentioned above its generally a relatively poor performer. As a result, inflation affects poor performers more than strong performers. In the last few years, after inflation, fixed income returns where actually negative. You simply need more performance otherwise the road to retirement can take years or even a decade longer.
What are the benefits?
Well, not many. But in the very short run they are less volatile than stocks. They are also less correlated to the stock market which means that a portfolio holding both of these assets are a little less volatile as a whole. For those who like to hold cash in their portfolios (bad idea) fixed income is better suited to hold value until its needed. The “appearance” of lower risk also provides small investors a better ability to sleep at night.
Will I invest in Fixed Income?
Absolutely not. I play a long game where its in my best interest to stay with better performing stocks. Yes in the short run, fixed income can out perform and even sometimes in the long run (rare), but no one knows when and for how long. Very long run returns for stocks are generally known to be between 9-10% while fixed income is around 5% give or take. The difference can narrow substantially depending on what part of history you are measuring. Nevertheless, stocks almost always win in the long run, so it rarely makes sense to invest in fixed income. The few benefits simply do not make up for the underperformance. I get allot of slack for this view but its all verifiable.
What If….
Ok, never say never. What if returns on fixed income increase to 15% while stocks languish. Well, I may be convinced to adjust the strategy in the short run. Small investors have to stay nimble as market dynamics change. I had come across a few smart investors in the 80s who locked in 18% bonds and as rates fell back, their bonds skyrocketed in value. Under the right circumstances, an adjustment of strategy may be beneficial.
So what now?
In fixed income, interest rates are almost all that matters. With rates at 4-5% a drop back to zero would benefit anyone with a portfolio full of long duration bonds. But should inflation persist which requires rates to rise, then that same portfolio will lose value quickly. If you don’t care about values and plan on holding your bonds till expiry in lets say 20 years, then it doesn’t matter as you will receive your money back as well as 4-5% interest per year as expected. So for me, rates are simply not high enough to get me into bonds. How high do they need to be? That is a difficult question, but I suspect I would be much more interested if rates were over 10%.
So where are Rates going then?
In economics there are always many forces trying to move the economy, lots of moving parts. Inflation is going down which suggests that rates may be lowered soon. Also the yield curve is inverted meaning the market is not expecting rates to remain high. You get less return the longer you go out on the bond term which is counter intuitive, its almost always higher. It also means that a recession may be ahead, or at least a slow down is coming. The inverted yield curve is generally a good indicator of recessions, but is not always right. The moral of the story is that generally rates are expected to fall, but no one knows for sure. In my experience strong trends in rates tend to last longer than expected. This means that I would not be surprised if rates stay in the 4-6 % range for a couple of years.
Driving the point home
This is a sort of a real story about investing in fixed income related to my parents. I was asked by my mother to set up a fixed income ladder for money she inherited from Grandpa. A ladder in this case, was simply staggering 5 term deposits, one due every year for the next 5 years. Meaning there was always a term due every year, and those funds were usually reinvested to keep the ladder going. It took advantage of longer durations and did not tie up all her money. My mom hated risk.
Dad on the other hand was good with risk, he once owned a motorcycle and a race boat. He had invested his own money in lousy stock mutual funds. Over 30 years later, my dad had significantly outperformed mom even with a not so well thought out investments. It was quite surprising, although dad started with a little less than mom, he finished with likely 3 times more. As I recall, earlier years saw their returns much closer, and Dad had some bad years from time to time but as compounding continued and rates kept falling mom’s returns lagged more and more. Some of Dad’s good years were really good, for example in 2013, my dad returned over 20% while my mom gained a mere 2-3%. This real life example shows how being too conservative can actually be counter productive to achieving ones financial goals. Thankfully my mom and dad’s approaches averaged out to something still somewhat acceptable. But what if my mom was alone? She would have definitely had to eat cat food in her old age.
Marc’s Monthly Moves
- Sorry no Moves
Marc’s Portfolio YTD Performance
- Portfolio return: 18.9% (including currency gains)
- Portfolio return: 17.7% (without currency gains)
- S&P 500 return: 17.6%
- RSP ETF S&P equal weight 3%
- TSX: 4.08%
The portfolio is once again neck and neck with the SP500 after a strong run up. There is definitely some rotation going on in my favour within the market. The currency gain is also nice, but I do not count it, as performance goes.
Money with Marc 