Quarterly | April 27, 2021 | Brendan Greenwood CIM, QAFP, B.Comm
Bonds may no longer provide the protection you think. Here’s why…
The US, the largest economy in the world has grown on average 3 percent a year since 1948 (Source: tradingeconomics.com). The Federal Reserve has forecasted average growth of 6.5% for the US economy this year, a big increase over it’s long-term historical average. The optimistic forecast stems from unprecedented stimulus that has helped lift the economy from a deep recession and an effective vaccination program effort. More than one third of the US is already vaccinated and will be almost fully vaccinated before the end of the summer based upon the current trend line (see chart below).
Here comes the risk of holding bonds in your portfolio:
The nominal GDP growth rate has been declining since the 80s, along with interest rates. This created a bond bull market where bond values rose as interest rates declined helping provide good risk adjusted returns for balanced (60% equity 40% bonds) portfolios.
After experiencing negative growth caused by the pandemic lockdown and near zero interest rates, it is likely that as the economy reopens and GDP growth accelerates we may see a rise in interest rates in order to maintain the federal reserve’s long run inflation target of 2%. This would result in a fall in bonds prices, with a greater impact on bonds with longer durations.
The 1970s were a period of rising nominal GDP growth and rising interest rates. The Risk Return chart below compares risk adjusted return for different asset categories (with the lowest risk furthest to the left). During that decade, from a risk perspective long term government bonds had a substantially higher probability of having negative returns than small cap stocks.
Alternatives to bonds to manage downside risk in your investment portfolio:
Here are some diversification options that you may want to consider given the changing risk profile associated with longer term bonds:
· Cash equivalents
· Ultra-short term corporate bonds
· ETFs that combine covered call and put strategies
· Funds of hedge funds
· Precious Metals
· Non-cyclical defensive sectors
Ensuring you manage the downside risk by incorporating alternatives to traditional bonds in your investment portfolio will be important in preserving and growing your wealth in the years to come.
How corporate class mutual funds and ETFs can reduce your annual tax bill
If you earn taxable income and have money invested outside of a registered account a large portion of your investment income will be lost to taxes. Investing in corporate class mutual funds and ETFs outside of your registered accounts can help lower your annual tax bill through the tax deferral a corporate class structure provides. This leaves you with more pre-tax dollars to compound and grow over time.
For retired individuals who receive OAS, if your taxable income exceeds $79,854 you will be subject to claw-back by CRA of some or all of your OAS monthly benefit. Investing in corporate class funds and ETFs help lower your taxable distributions which could help prevent you from losing all or some of your OAS income benefit.
Business owners like to keep money in their business to avoid paying tax at their personal income tax rates which can be over 50%. There are two challenges with leaving money in the corporation and investing it.
· Passive investment income earned within a business is subject to high rates of tax.
· When this investment income exceeds $50,000 it starts to reduce the small business deduction increasing the rate of tax on active business income.
Corporate class funds and ETFs provide a useful tool for businesses to defer tax on investment income and can help your business avoid losing the small business deduction on your active business income.
A conversation with an advisor can help reaffirm whether it makes sense for you to invest in corporate class funds and ETFs to reduce your tax exposure. When investing in corporate class funds or ETFs it is important to do a thorough evaluation of corporate class investments available and any money mangers that may be involved.
With the current low interest rates, borrowing to invest can be an attractive option for individuals with substantial equity in their homes. The interest expense is deductible for non-registered investments. If you are considering this strategy, interest rates are expected to rise from historically low levels reached last year. Instead of applying for a traditional variable rate home equity line of credit (HELOC), consider applying for an interest only mortgage that allows you to lock in a fixed rate. This will protect you from the risk of rising interest rates as the economy continues to recover.
When borrowing to invest, remember that the market moves in two directions (up and down). Borrowing to invest is not a strategy that is suitable for everyone. It can result in much greater losses than simply investing available cash, although it can be a valuable tool for informed individuals. Its important to fully understand and be able to manage the risks such as a decline in financial markets, a rise in interest rates or a drop in income. Before implementing any sort of leveraging strategy talk to your advisor about the various approaches you can take to reduce interest rate and market risk.
Brendan Greenwood is an Investment Advisor with Worldsource Securities focused on personal pension strategies and leveraging technology to provide progressive institutional style investment solutions for professionals, incorporated individuals, business owners, retirees and their families.
For other articles authored by Brendan Greenwood on issues impacting business owners and individual investors see https://www.greenwoodwealth.co/blog.
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