Fixed-income securities offer stability

Bond and mortgage funds, treasury bills, stripped bonds and coupons and mortgage-backed securities help reduce short-term volatility and risk. Also, some of their timing features come in handy when planning for retirement.

Canadian stocks have logged some solid returns over the past few years.

But given the late-August sell-off in markets worldwide, investors are now justifiably skittish about putting money into equities. Of course, abandoning the stock market over the long term is never a good idea.

Still, if you’re worried about the market’s volatility over the next few months, here are some other types of investments that you might now consider.

Bond funds and mortgage funds

Thanks to falling interest rates, funds with fixed-income holdings were an excellent investment during much of the 1990s.

But since the market meltdown of 2008-’09,  the Bank of Canada and the U.S. Federal Reserve Bank have aggressively cut rates to try to jump-start the economy.

Yet it’s almost certain that at some point, both countries will increase rates to try to slow the inflation that inevitably occurs when rates are cut.  This raises interesting issues for income investors.

Normally, bond and mortgage funds are more stable than those that hold stocks.

So, if you buy bonds or fixed-income funds mainly for interest income, swings in stock prices shouldn’t worry you too much.

After all, your stockholdings will still generate income. And as long as you don’t sell when prices are down, you should be fine.

Keep in mind that bond prices and interest rates are inversely related. When one goes up, the other goes down, and vice versa. Moreover, the longer the time until a bond matures, the more its market value will fluctuate with changes in interest rates.

So, if you want to reduce risk when investing in bond funds, consider those funds that hold short-term bonds.

Another type of fund worth considering is one that holds real return bonds. Issued by the government of Canada, these funds are designed to protect your principal and your interest payments against rises in the consumer price index.

Mortgage funds, which invest mainly in residential first mortgages, are more stable than bond funds. They also boast an excellent safety record.

One reason for the stability of mortgage funds is their shorter time horizon. Indeed, their average holding has a term of just three years. So, like short-term bond funds, rising interest rates pose less of a danger.

Moreover, you don’t have to pay a sales commission when you buy a fixed-income fund. Nor do you have to pay a redemption charge when you cash out.

Treasury bills

When short-term interest rates are high, there’s no better place for your money than Government of Canada Treasury bills, or T-bills.

Although T-bills aren’t as attractive when rates are low, they’re still a good place for safety-conscious investors who may want to park some cash. T-bills are especially useful when short-term rates are rising and when there’s uncertainty in the stock market.

T-bills, which help the government finance its operations, come in three terms:  91, 182 and 364 days. But you can buy T-bills from a broker in a variety of maturities — usually for as short as one month, or as long as a year.

As suggested, the key advantage with treasury bills is safety, given that they’re issued by the federal government.

You can usually buy treasury bills from your broker, but the bigger ones often offer the best returns. And although the minimum purchase will vary, it will typically be $5,000, or sometimes, $10,000. If you don’t have a brokerage account, you’ll have to open one unless you have a pile of money — $50,000 or more — to invest. In that case, you can buy treasury bills through a bank.

Stripped bonds and coupons

Stripped bonds offer competitive interest rates, predictable yields, along with a timing feature that makes them particularly valuable when building your retirement nest egg.

Take a government of Canada bond with a face value of $1,000, maturing in 10 years and paying two per cent interest. This bond has two separate components: the bond itself and its coupon (or interest) payments.

In other words, you can buy only the bond, obviously at a discount, holding it until it matures. Or, you can buy the coupons at their present value, cashing them when they mature.

Unlike guaranteed investment certificates, or Canada Savings Bonds, stripped bonds allow you to lock in an interest rate for 15, 20, or even 25 years. In this way, you can pick a maturity that jibes with your retirement date.  Alternatively, you can stagger your maturities, so you get a regular cash flow.

Stripped bonds should always be regarded as long-term investments. And keep in mind that “strips” pay no interest. You only collect when the bond matures. In other words, “strips” aren’t suitable if you need regular income.

Moreover, stripped bonds and coupons are very volatile. So, as interest rates move, their values will rise and fall much more sharply than ordinary bonds.

Finally, “strips” carry important tax considerations. You have to declare accrued interest on your strips and pay the appropriate tax every year, even though you won’t have received any income.

Although stripped bonds do best as a long-term investment, some folks like to trade them on a regular basis. If that’s your goal, you’re best off buying “strips” when interest rates are high.

Mortgage-backed securities

One of the safest investments anywhere, mortgage-backed securities offer competitive returns, as well as a monthly cash flow. Often called NHAs, after Canada’s National Housing Act, mortgage-backed securities offer a share in a specific pool of top-quality residential mortgages.

As with bonds, prices for mortgage-backed securities reflect current interest rates.  So, the coupon only matters if you’re buying the original offering.

Dated as of the first of the month, mortgage-backed securities start paying returns on the 15th of the month following the issue.

Although most mortgage-backed securities last for five years, their terms can run for as little as six months, or as long as 25 years.

 

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846