What to do about bonds and preferred shares now

Every month the Money Reporter, the newsletter for investors whose interest is more interest, publishes its list of recommended bonds and preferred shares.

What to do about bonds now

Coporate_Bonds Of the three main asset classes, fixed-income securities have outperformed cash so far this year, but not equities. Year to date the FTSE TMX Canada Universe Bond Total Return Index is up 2.1 per cent, while the S&P/TSX Composite Total Return Index is ahead 8.0 per cent. We expect the same thing to happen over the next year.

Corporate bonds have outperformed government bonds this year as the default risk premium on corporates has come down.

Our overall recommendation for the bond portion of your portfolio comes in two parts.

First, although inflation remains stubbornly low, the global economy is experiencing synchronized economic growth. Consequently, inflation and interest rates should gradually pick up over time. We think an underweight in bonds is called for.

Second, we advise you to maintain a short average term to maturity for your bond holdings. Concentrate on issues with terms of five years or less. Fairfax Financial’s 5.84-per-cent-coupon-rate BBB corporate bonds look attractive right now yielding about 3.13 per cent to maturity on Oct. 14, 2022.

What to do about preferred shares now

The preferred share market has outpaced the bond and equity markets this year. The S&P/TSX Preferred Share Index is up 8.6 per cent year to date.

Some of the factors that account for this outperformance include good economic conditions and favourable corporate creditworthiness. But the decision of the Bank of Canada to raise its overnight target interest rate twice this year had a large impact on the rate-reset component of the market. These issues stand to benefit from higher interest rates as their dividends are occasionally reset to reflect the interest rate environment.

The Bank of Canada’s rate hike has a similar impact on floating-rate preferreds, explaining why our floaters have outperformed our straight fixed dividend payers since the summer.

With inflation remaining stubbornly low, the Bank of Canada is less likely to hike rates as rapidly than was hitherto thought to be the case. Nonetheless, it will probably increase rates next year, benefitting our floaters further.

This is an edited version of an article that was originally published for subscribers in the November 17, 2017, 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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