Why Do We Own Bonds?

We often discuss having balance in a portfolio as a concept that can and does, at times, prove itself out when we are forced to endure the fallout from extreme shocks to the economy that create enormous amounts of volatility in equity markets.

A cursory glance at our client portfolios with a heavier weight in fixed income securities (bonds) this morning reveals a year to date return somewhere between -4% and -5%, a welcome sight for those who are less tolerant of big swings in their portfolios.

Importantly, some of this portfolio value deterioration is from the downward price adjustment to their bond holdings, which can and may be just illusory and temporary because we know that bonds will mature at a certain date in time and repay the bond holder the original issue value unless, of course, the bond issuer defaults (herein lies one of the risks).

In the interim, the bond pays the bond holder a payment (usually semi-annually) that is the coupon interest rate which is fixed when the bond is issued. Hence the term "fixed" income.

Because bonds do trade in a secondary market, where buyers and sellers for their various reasons (perhaps buyers looking for value in income assets or sellers looking to raise cash) meet to transact at a set price.

That set price may be above or below the issue price, depending on a number of factors:

1) current interest rates

2) the length of time to maturity (duration)

3) inflation expectations

4) issuers credit rating (risk of default)

Let's, for example, say that we bought a bond at issue ($100). The coupon (annual interest payment) was 4% and it matures in 5 years. So, if we hold this bond to maturity, we get annual income of 4%, each year for 5 years. 

Say we bought $10,000 worth. We get semi-annual payments of $200 cash. This is income (and taxed as income FYI).

If, at a future date, because another holder of this same bond gets concerned about interest rates going up (because inflation is creeping higher / economy is getting stronger or the issuer goes from a BBB rating to a BB rating), they may want to sell this bond. If a buyer in the secondary market only wants to pay $90 for the bond and the seller and buyer transact, the buyer is getting a discounted price for the semi-annual $200 guaranteed income stream.

The secondary market buyer gets $400 per year on his investment of $9,000. Simple math for this example, is an annual cash yield of 4.44%.

If there is 4 years left to maturity, the secondary market buyer will get $400 for 4 years = $1600, plus $10,000 at maturity ($1,000 capital gain) for a total return of $11,600 on a $9,000 investment. Simple math (not taking into consideration the reinvestment of the semiannual $200 interest payments) suggests a $2600 total return over 4 years or about 7.2% annualized.

Still with me?

What about our bond that we still hold?

In our portfolios, it is now valued or "marked to market" at the new price: $90. Which would show in our portfolios as $9,000 and an unrealized "loss" of $1,000.

Our "loss", unless we decide to sell (maybe we think we can buy it back at $80-85 sometime in the future?) is not realized if we hold the bond to maturity and the issuer of the bond pays us back in full ($10,000) and we have collected the $200 semi-annual interest payments. 

So what may look like reduced portfolio value after year 1, will end up being mitigated by year 5 (bond's maturity) as long as the issuer does not default (which is a risk that we must always monitor). A good portfolio manager will continually assess the default risk in a bond portfolio. Something that you may not get in an ETF.

Nonetheless, total portfolio value is a combination of the prices of all assets at "mark to market" on a given day: bond prices, stock prices, ETF prices, mutual fund prices, etc.

But, if you have "unrealized" bond losses, but plan to hold the bonds to maturity, you can discount these losses somewhat and the lower portfolio value becomes a bit misleading (as well you are receiving income stream into the future, to the bonds maturity, which is not included in the mark to market).

Remember that the "mark to market" of a portfolio is there to inform you that if you were to sell everything at that point in time (for most long-term investors an unlikely scenario) that would be the cash value you would receive.

Sometimes the safety factors built in to bond ownership are not necessarily completely built into the portfolio value. Especially when there are selling factors for bonds, whereby some investors and traders just need to raise cash at any price, some of which we have seen recently with the economic shock from the  coronavirus.

As markets settle, so will bond prices (as long as issuers are not defaulting) and it helps that the Bank of Canada is buying bonds to give the market needed liquidity.

This is what a client had to say, yesterday:

 I had a feeling something like this was on the horizon but the other guys kept saying there's more growth out there. Our switch to High Rock was timely and saved us some heartache. We're not worried at all and are sleeping well. TE

I Sure Want To See Some Positive News...

 But Let's Not Get Too Far Ahead Of Ourselves

Apparently we are now (technically) in "bull market territory" with some indexes at or better than plus 20% from their recent lows. The business news media (or as our friend David Rosenberg refers to them as: "bubbleheads") are all over this.

Please, please, please, please, PLEASE, my friends, take this all with a grain of salt.

We have not even seen the peak of the Coronavirus curve yet.

Yes, the central banks and the governments are promising fantastic and unprecedented support to the economy, but keep in mind, whether it was expected or not, as of last Friday, 3.28 million Americans became unemployed (filed for jobless claim benefits), which dwarfs any previous data since they started collecting it:

This  could spike the unemployment rate to 10% or higher. So, that will now take the U.S., almost officially, into recession. The Canadian unemployment claims case (estimated at over 1 million now) is perhaps even more significant.

Just think of the domino effect here. 

Despite a cheque for $1200, or whatever the government is going to send you, are you going to go out and make anything other than necessary purchases (food, meds, etc.) and cover rent or mortgage payments?

Certainly, at the least, big ticket items will be forgotten, at least for the time being. Consumers will not be consuming. Businesses will not be investing, they will be doing everything in their power to conserve cash (which may mean more unemployment). Earnings guidance is already being pulled.

This is not going to be a "V" recovery like the 2019 bounce, despite what stock market "cheerleaders" want you to think. In fact, I would be extremely skeptical of any advice that suggests that stocks are going significantly higher anytime soon. There is a greater likelihood of another wave of selling when the economic reality starts to settle in. We have to be prepared for that.

The lesson from 2019 was that we didn't pay attention to the fundamentals: economic growth was stalling (remember the trade war?), earnings growth was negative but stocks went higher on hot air. How did that end up?

Instead, get back to your long-term plans and strategize around them. Prepare for the possibility that this might all last a little longer than we might be being lead to believe by the overly optimistic who want to sell you something on their over-confidence.

Please have a look at my blogs from December 29: Expect The Unexpected (Again) or February 13's: Over-confidence .

You may not find what I write laced with wit and humour, but merely a bit of perspective from which to help you make some key financial decisions. What carries greater weight for you, a sales pitch from an advisor or well thought-out coaching?

 Think about who might best have your back when you need it most.

Stay safe! Stay healthy!

Hunkered Down

Plenty of conversations with clients this week so far and a broad range of discussion topics, here are a couple of them:

1) "Am I going to be O.K.?" (from an 80 plus years young client, currently under lock-down in her retirement community).

With a Wealth Forecast that took into consideration her financial needs for cash flow and a more fixed income oriented strategy (light on equity market exposure) that created an annual income stream and with plenty of cash in the portfolio to weather financial market disruptions: Absolutely and resoundingly: Yes!

2) "With the prime rate down 1% and borrowing room in my LOC, is it a good time to be putting more $ into my investment portfolio (from my LOC) to take advantage of lower prices?"

That is more complicated. There are opportunities out there. With the Bank of Canada buying bonds and putting a bit of a floor under the corporate bond market, Paul (probably one of the most knowledgeable bond managers in Canada) suggests there are really good opportunities to add yield to your portfolio: 

"With the cost of funds having declined (and may likely decline again) the yields on higher-quality bonds higher, yes now may be the time to borrow and invest in income flowing bonds. In fact we are talking to a few clients and prospective clients about doing this. However, leverage is very risky and requires a full understanding of how it works to the upside and downside."

If you can borrow at 3-4% and get somewhere in the vicinity of 10% in annual bond coupon interest, there is a tidy spread to be had and the interest on the borrowed $ is tax deductible. Remember that as long as the companies meet their obligations, the bonds mature at their issue price. If you can get them at a discount to the issue price (below $100), there is some potential for capital appreciation too. Obviously, in times like these there is greater risk that companies default, but with the monetary and fiscal stimulus being added by the Bank of Canada and the federal government, this risk is being reduced.

This strategy is not for everyone and should only be part of a strategy that is managed by a seasoned portfolio manager with a high degree of expertise and dependent on your financial circumstances, time horizon and tolerance for risk. We can help you make that determination.

 Should you be loading up on stocks with borrowed money?

There is plenty of uncertainty in the world: We all have one eye on the Coronavirus stats, trying to get a sense of when this might peak and the economy can start back up again.

In the meantime central banks and governments are providing plenty of stimulus and liquidity. 

My defensive minded nature (yes that is me in the above photo, I played that position for 51 years) tells me that much of the price action in stock markets right now is short-term trading, driven by algorithms and computer generated. The blow-out in stocks forced a lot of the "leveraged" holders out. Long-term investors, passive strategies for the most part, are still holding on. If they start to get unnerved, that could be enough to force another move lower in stock markets. The computers will jump on this and try to take advantage of the downward momentum.

That may happen when we start to see the huge drop in the economic data. So far and it is still early going, the data for March has been weaker than expected. This could get a little scary as we try to determine if the stimulus packages are enough to offset the economic weakness.

It is all about confidence. If confidence, which has virtually vanished, returns, the economy could bounce back quickly. However, only a slowing of the Coronavirus stats will be able to do this and that is one big wild card.

Our strategy for buying into equity markets (as we have been under-weight our target allocations in this asset class) is to gradually layer in small percentage equity weights to the Global Equity Model to gradually reduce our under-weight allocations.

We continue to be hunkered down and defensive minded (until otherwise convinced). With plenty of ammunition.

We Will Get To The Other Side Of This

By nature, I am a cautiously optimistic person. History tells us that the best leadership rises in times of adversity and all the people who come together to battle this adversity (Coronavirus / Covid 19 and the fall-out) will ultimately prevail. There will always be skeptics, but by and large there will be more of those of us whose common strength will become greater than the challenges we face and we will all be better for it.

My football coach (many years ago) believed that "the best offense was a good defense". That always stuck with me. I think it is an important part of my psychological profile and why I believe that gambling has no place in investing. I never had time for the news and business reporting that announced each trading day as a "winning" or "losing" day on Bay and /or Wall Streets. Investing is not a game. Investing is a long-term strategy of building wealth by purchasing assets that grow in value and / or provide an income stream.

Our long-term focus (at High Rock) will see us through the current crisis. We need to be willing to accept that there will be (and there already has been) a significant amount of financial market volatility. But we shall get through it. We will get to the other side of it.

Importantly, now we need to focus on what matters most: family and friends and especially those who are in greater need than we are. And don't forget to thank those folks that we encounter who are on the front lines: medical professionals, caregivers and workers, grocery store and pharmacy employees, even the politicians and government administrators who are working tirelessly to try to soften the economic blow.

We will all be asked to make some sacrifices for the common good: we have clients who traveled to Singapore and Vietnam on a pre-planned vacation and returned to have to self-isolate for the required two weeks at the end of which they started a drive south to Florida only to have to turn around when it was announced that the borders were closing and endure another period of self-isolation when they returned. We have others who have had to cut their normal time in warmer climates short and some who have chosen to hunker down where they are.

We have remote technology at High Rock, so we are still able to serve all of our clients despite being in "lock-down mode". We understand the needs of parents with school-age and younger children who have no options but to be at home with their kids and also try to work as well. Our CFP Bianca finds herself in in that situation.

We will all have challenges, but if we come together, as a society, as human beings, in a time that we need to come together, we will also find some common solutions to our challenges and this will help us all move forward. I heard two words today that resonated: kindness and courage!

Stay safe, stay healthy, stay strong.

And maybe check out Yoga with Adriene to help get you through the long days of being home. Definitely works for me!

We look forward to seeing you on the other side!

Yesterday, Cash Was King

Balance in a portfolio was handed a solid thumping yesterday as investors who had borrowed to invest turned to anything with value to sell to cover their margin calls: the Canadian bond index ETF (XBB), dropped almost 7.5%. That and the likely fact that governments will be issuing a whole lot more bonds (supply) in the not too distant future to cover all the new spending announcements. The other very borderline suggestions for balance by some advice givers, Preferred shares and REIT's, have also been walloped:

Fully invested folks hopefully knew what was coming and are hunkering down to ride this out. After 2008 - 2009, fully invested balanced portfolios (60% Equity /40% Fixed Income) took a little over a year to bounce back. 

As Paul suggested in his blog yesterday, we (at High Rock) have been over-weight cash. Not at all because we saw the Coronavirus coming, but because valuations for stocks were so over-extended. (See most of my 2019 blogs). So we gave up a little on 2019 returns (not quite able to keep up with the benchmarks), but with the benchmarks down almost 20% year to date, our client portfolios are down a fraction of that.

Here is some of the feedback we have been receiving:

"Hey Scott, you folks must be busy. I just read your blog and have been thinking lately about our timing to switch over to your firm. So glad we did. I wonder where we would be at right now if we didn't."

We worked it out yesterday. Close to down 25%.

"...funny we have no trouble sleeping considering the market slide, worrisome on the health risk though...Good job HRC. Much appreciate it".

"All I hear are people going to cash and how their retirement slipped by 10 years based on their 401k... Then I think about how different we have it... thank you for this reassurance."

So now, with our cash on hand, we are value hunting, something we have been patiently waiting to do.

To all the passive investing folks, hang in there, keep the faith, don't go to cash. 

When this is all over, give it some further thought and perhaps contemplate the expertise of portfolio management to have a nice combination of passive and tactical strategies working in unison. Strategies that will bounce back faster (because they didn't go down as far) and get back to the business of growing to provide a better chance at your long-term goals.

In the meantime, we are standing by to talk strategy with anyone who wishes.

The Cycle

Time to pull this one out of the closet and dust it off. Notice, however, that there is no timeline on the vertical axis, so we may have our patience tried while we wait out the current situation.

I think the best I have read recently is an opinion piece by Barry Ritholz on  Bloomberg titled "Some Rules For Coping With Stock Market Panic". I would highly recommend giving it a quick read (just click on the highlighted title).

"People don't like being told what to do, and when agitated they really dislike being told to be less agitated. So rather than just tell you not to panic (seriously, DON'T PANIC), I will offer some thoughts about what is going on today, this week and perhaps the next quarter or two... and it's worth being skeptical of anyone who says they know how this will turn out".

For the last 11 years or so of the bull market in stocks we have been told that "passive" portfolio management was best. We are not always active (trading day in and day out), weeks or months may go by with little or no trading activity, but since somewhere in the middle of 2018 we have been reluctant to spend our and our High Rock Private Clients hard earned $ on over-priced equity assets, despite a good deal of folks disparaging our cautious stance. We did continue to look for value and opportunity where we believed it existed, but it certainly was not in being fully invested in passive equity index ETF's. We were partially invested, we did not miss out on the upside completely.

We are certainly not sitting on our hands at this time, either, as we scour the markets, patiently looking for value opportunities to arise, without gambling away our or our client's money. It certainly is nice to have the cash on hand to be able to do so.

Most of the calls I am taking this week are from clients thanking me for our patience, our diligence, our caution and our stewardship. Imagine that?

Portfolio Balance

It happens in times like these (equity market duress), we get to see how the other side of the equation in the balanced portfolio actually holds up to scrutiny.

We often get the question: why do we want government bonds in our portfolio when the (coupon) interest rate is so low?

If your risk assets (equities) are undergoing price re-discovery (how is that for a term to replace "trounced"?), the fixed income portion of the portfolio is intended to provide some temporary relief (upside in price) as it balances out (mitigates) some of the downside from the equity portion.

In times of equity prices rising, this may seem like a bit of a drag on the total portfolio, but as we saw yesterday (and over the last couple of weeks) having the counter balance is somewhat soothing in light of the turbulence in your portfolio provided by your equity holdings.

As I mentioned in my blog on the weekend, limiting the downside in times of duress means a quicker recovery and getting back sooner to the growth trajectory, which is ultimately the purpose of investing.

When you do peek at your statements and / or performance summaries next, it might be a major disappointment to see all the gains of 2019 disappearing with the losses of 2020 and taking you back to the beginning of 2018 with little to show.

 With the right balance, it may not be as disappointing.

Unfortunately through an 11 year bull market in stocks, the whole balance theme tends to get watered down. When we should be focusing on true balance, some start to cheat a little on yield.

Preferred shares were one such animal. When they were fixed rate perpetual preferred shares, they provided excellent, tax efficient dividend yield and until they reached the dates that the issuers were allowed to redeem them (so they were never truly "perpetual" really). 

Sometime in about 2014, however, when many of the remaining perpetual preferred shares started to get redeemed, the financial institutions (mostly), reverted to issuing something called rate reset preferred shares, which allowed the issuers to reset the dividend every 5 or so years. This added some complexity to these preferred shares and took away the "fixed" returns that the perpetuals had provided and became more of a floating rate investment. Good when interest rates go up, but not so much when they go down (not so much "fixed" income anymore).

The problem is that through 2014 and into 2015 the proliferation of these rate resets found their way into the preferred share indexes and hence the ETF's.

More astute portfolio managers (my High Rock partner Paul, who has developed an expertise in these issues, for one) realized that these new preferred's were not going to be a good defense against plummeting stock markets and central bank interest rate policies (lowering rates) as good balance in a portfolio.

So we took appropriate action and reduced our exposure back in 2015. Subsequently, rate reset preferred shares tumbled when oil prices fell (last time the Saudi's amped up production) and they actually became very cheap as the BOC lowered rates, so we added them to our portfolio.  Then in 2016, when rates started rising again, so did the prices for these rate reset preferred shares. 

Point here is that the underlying change in the structure of these issues has to be considered. When a new client transferred in last December with a whopping 15% of this DXP ETF, we could not get rid of it quickly enough.  Preferred share ETF's have fallen by close to 17% this year, 9% yesterday alone. Ouch if they were 15-20% of your total portfolio or 1/2 of your fixed income balance, because that is no cushion to falling equity prices.

For buy and hold type portfolios, this has to be a big problem. You are going to have to wait for interest rates to start going up again for these rate reset preferred shares to do the same. If you think that this is going to happen soon, given the current economic concerns, think again.

Real portfolio management means re-assessing what exactly offers a portfolio protection and balance.

Fear and Loathing

(With special thanks to Grahame Arnould for his contribution, above)

There has been no shortage of opinions bandied about in the media this week both in the regular news and on the social sites.

Financial markets are obviously undergoing severe volatility, likely exacerbated by computer generated algorithmic trading activity and perpetuating the fear factor. 

I will leave you readers to your own determination of the quality of the political leadership on display.

If your financial advisor has been in touch, I am certain that their words have been soothing, panic should be completely discouraged. I have seen some of the written advice, everything from "don't look at your statements" to the classic reminder that you need to remember that "you are in this for the long haul".

If you are in a fully invested "buy and hold", one size fits all style of portfolio, you have little choice other than to ride the waves of the storm and hope that it blows itself out without wreaking too much havoc, both financially and emotionally. It is never an easy prospect to gamble your future on hope.

Basically, at this point in time, your balanced, globally diversified portfolio is likely not a whole lot different than it was at the beginning of 2018 (unless you are more invested in bonds than equities):

Some might use preferred shares for their balance (gold line above), but that has not likely been working well of late.

An individually tailored portfolio has the benefit of taking into consideration your personal timelines (i.e. when you might need to rely more on your on portfolio for your lifestyle expenses) and your personal risk tolerances.

As well, if your portfolio is being re-balanced regularly, it leaves it less vulnerable. 

Even further, portfolio management (vs. a buy and hold strategy) may be able to reduce the enormous impact of the volatile times and leave opportunity to find value when it appears in times of financial market duress.

The basic tenets of long-term planning and tailored and appropriate investment strategy are important tools in minimizing downside risk so as to be able to limit the portfolios recovery time when the distress abates.

From what we have been able to ascertain from medical experts, the Coronavirus (Covid-19) is eventually going to touch the majority of us. It is the uncertainty created and the loss of economic confidence (consumers and businesses postpone spending and investing plans) both from a supply and demand perspective that is going to hamper economic growth and very likely create a recession. A vaccine is not expected for at least 18 months.

Central banks can only do so much, but they certainly cannot create economic demand with lower interest rates but they can create false and dangerously over-priced assets that have proven to be problematic as investors try to find what real value actually is.

Corporate earnings estimates are being revised significantly lower over the next year, adding greater uncertainty to current valuations.

The near future could be somewhat trying on many levels, however changing your goals or worse, drastically altering your financial plan in panic, may end up in disaster. 

It is time to take stock of your situation, create and /or update your plan and make the minor adjustments necessary, but always keep the long-term goals at the forefront.

Most importantly, don't let the hype (cheerleaders and doomsayers) force you to make any major changes. If you feel tempted, seek out good, solid advice / coaching to assist you in any decision making process.

At High Rock, where we believe in disciplined investing, we are always standing by.