Bonds show why they belong in your portfolio

Although many investors buy the units of real estate investment trusts, or REITS, and other high dividend-paying stocks for their attractive income — and maybe also for capital appreciation — we think you should not consider these as replacements for fixed-income investments. That’s because their income is not fixed and your capital is at risk.

For instance, high dividend-paying stocks that invest in the energy sector have suffered a significant setback since the summer.

The problem with income stocks and REITs, in contrast to fixed-income investments such as bonds or GICs, is that the former have no maturity date at which you receive par value for them. To acquire and dispose of them, you’ll have to buy and sell in the stock market for whatever the going price is.

Meanwhile, the distribution of an income stock’s cash flow depends on the ability of the business to pay. The business can cut distributions — to zero if necessary — without ongoing obligation. Bonds, however, must be paid out in full with interest before anything can be paid to shareholders. It’s a risk you should consider before buying income stocks and REITs.

What to do about bonds now

With stock prices falling and cash generally paying next to nothing, you would hope the middle asset class — fixed income — would pick up the slack. That’s not been the case so far this month, as the FTSE Universe Bond Index is down 0.1 per cent.

But as we approach 2015, it looks like bonds may indeed outperform equities for the year. Year to date, the S&P/TSX Composite Index’s gain has withered to about four per cent, when earlier in the year it looked like it might close the year in double-digit territory. The Universe bond index, by contrast, is up 8.1 per cent year to date, with governments returning 8.5 per cent and corporates 7.1 per cent.

Recent market action explains why you always need a healthy allocation to fixed income for diversification purposes. We recommend a fixed-income allocation of about 35 per cent for persons of average risk tolerance, composed of GICs, or split between government and corporate bonds. The returns aren’t great these days, so we recommend you give slightly more weight to corporates.

Every month the Money Reporter publishes a table of bonds recommended for current purchase and lists of the best GIC rates available in Canada.

 

Money Reporter, MPL Communications Inc.
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