You will get the most from your income portfolio by following the four guidelines below. Also, be sure to own at least one good dividend or equity income fund, and, perhaps counter-intuitively, don’t buy bond funds.
Aim for the best
If you’re investing for income, here are four guidelines to help you get the best from your portfolio:
■ Be flexible. Prudent investors avoid relying too much on any one type of security.
■ Be aware of the real after-tax returns of your investments. When you compare the after-tax return of dividends versus interest, remember that those dividends you receive from taxable Canadian companies also come with the dividend tax credit. In Ontario, for example, an investor who earns between $144,490 and $150,000 a year should pay 46.41 per cent in combined taxes on interest income for the 2018 year. But the same investor should pay just 29.52 per cent in taxes on dividend income.
■ Know your own circumstances. Before you choose between capital gains or interest income, it pays to know how each will affect your own tax situation. Remember that in a non-registered investment account 100 per cent of income is taxable, whereas just 50 per cent of a capital gain is taxable.
■ Avoid locking yourself in to long-term investments. To give yourself a better chance, avoid bonds with long maturities (over five years). You may have to accept lower income initially, but you’re apt to have a stronger portfolio in the long run.
Own a dividend fund . . .
Diversified, conservative equity funds make good core portfolio holdings, of course. But conservative investors would also do well to include a dividend or equity income fund, such as the Dynamic Equity Income Fund among their core holdings as well. That’s because many successful investors who invest directly in stocks find that over the course of a decade or two, dividends supply up to a third or even half of their total return.
It’s true that capital gains can supply more spectacular returns. But they’re irregular, often disappearing or leaving capital losses as a stand-in just when you need them most.
On the other hand, dividends and income from high-quality companies or income trusts are a reasonably steady source of income. Better still, they tend to ratchet upward over the years, keeping up with or exceeding inflation.
So be sure to consider a good-quality dividend fund for your equity portfolio.
We include four dividend and equity income funds in our Mutual Fund Planning Guide. In addition to Dynamic Equity Income mentioned above, we recommend PH&N Dividend Income, RBC Canadian Dividend and Scotia Canadian Dividend Funds.
. . . but don’t buy bond funds
Many investors use bond funds for the fixed-income portion of their total investment portfolio. We think that’s a mistake. In bond funds, you have little control over the very part of your portfolio where control is most important. To achieve this control, we recommend you invest directly in bonds or GICs.
Most bond funds place little if any restriction on the terms of their holdings. They vary the terms to take advantage of (speculate on) swings in interest rates. That means that if you want to redeem units of your bond fund, the price you get will depend on changes in interest rates and the terms of the investments in your fund. Consequently, you may even lose money if you’re forced to redeem units of your bond fund at a poor time.
And for this, you’ll pay a management fee. The median Canadian fixed-income fund has a management expense ratio of 1.56 per cent. With interest rates still on the historically low side, there’s not much room for these funds to produce a decent return given their high expenses.
Our recommendation is direct investment in a portfolio of GICs or bonds. With such a portfolio you can tailor your terms to maturity to meet your future needs for cash, thus retaining control of your fixed-income portfolio.
This is an edited version of an article that was originally published for subscribers in the January 18, 2019, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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Money Reporter •2/11/19 •