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By Brenda Bouw
IE:Money
July/August 2002 Issue
With interest rates at near-record lows, conservative investors
are singing the blues. But you can still find decent income, without
betting the farm.
Maureen Roberts has lived through many economic dry spells in her
76 years, but it was not until the recent downturn that she really
felt the pinch. “Just when you think you have everything set
up, it turns out you haven’t” says Roberts from her
Vancouver home. “It is at the stage where I have to be careful
now about what I spend.”
Despite a modest pension plan, a registered retirement income fund
(RRIF) and years of buying guaranteed investment certificates, Roberts
says her income has dropped dramatically this year.
The main problem? Low-down, bottom-scraping interest rates. Although
the prime rate moved up a bit this spring, it was in the neighbourhood
of four per cent, a far cry from 6.25 per cent in May 2001 and 9.75
per cent in 1995. A few years back, a five-year GIC paid interest
of eight per cent. Today, you’re more likely to get around
4.25 per cent.
Low rates are fine if you need a loan to start a business or buy
a house, but they’re tough on people—particularly seniors—
who rely on their portfolios for steady income. “The interest
rate declines have affected all income portfolios. Personal accounts,
registered plans, corporate accounts, pension funds and family trusts
have all felt the reduction in income:’ says Adrian
Mastracci, a fee-only investment counsellor and president
of Vancouver-based KCM Wealth Management. “Investors
in retirement are particularly affected.”
Many of these people saved over the years to supplement their Canada
Pension Plan and Old Age Security benefits, says Randall Reynolds,
a chartered financial consultant. “Some lucky ones may have
federal government indexed pension plans, but the vast majority,
of these risk-averse Canadians look to interest incomes from their
guaranteed investment certificates and term deposits to make up
the shortfall in their monthly stipends," he says.
Their predicament, however, has been overshadowed by stock market
volatility “If the stock markers lose 30 per cent in value
in a short time, the newspaper headlines blare ‘Markets Crash,’
‘Black Monday!’ or ‘Dark Day For Investors.’
Interest rate risk can hurt just as much as market risk,”
Reynolds says.
Given the grim rate picture, where does the income-seeker turn?
Here’s a look at some of the options and how you should approach
them.
Adrian Mastracci, fee-only investment counsel
at
KCM Wealth Management, says, “The interest
rate declines have affected all income portfolios.
Personal accounts, registered plans, corporate
accounts, pension funds and family trusts have
all felt the reduction in income. Investors in
retirement are particularly affected.”
Savings accounts
Actually, savings accounts, with stupendously low rates, are not
for income seekers, but they’re often the place people stash
emergency funds. Keeping at least three months of living expenses
in a savings account is a good idea, recommends Julie Sheen, VP
term investments.
However, be sure to look for the high interest vehicles offered
by some institutions. One option is ING Direct’s investment
savings account, says C. Michele Wilson, a financial planner. Recently,
it paid annual interest of 2.5 per cent—compared to savings
account rates of less than half a per cent at many other banks.
Guaranteed investment certificates
GICs promise safety of principal and usually a rate of return over
a fixed period. Traditional GIC's—non-cashable, fixed rate,
one- to five-year products— have been favourites of the conservative
set for years. Recent returns on these plain-vanilla securities
range from 1.6 per cent for a one-year term to about 4.25 per cent
to 4.5 per cent for a five-year term.
But today, there are many variations on the theme, including products—for
investors with stronger stomachs—whose return is tied to the
performance of stock market indexes, such as the Toronto Stock Exchange’s
S&P/TSX composite index, or the Standard & Poor’s
500 index.
Investors should note that some market-linked GIC's put a cap on
returns. If the market goes sky-high, you’ll receive only
a portion of the gain. Also, be aware that if the market retreats
during your investment’s term, your return could be zero.
You will, of course, get your principal back at maturity
Returns can vary widely depending on the performance of the underlying
market. For instance, assume Investor A held a five-year, U.S. GIC
Plus from TD Canada Trust. Investor B had a three-year version of
the same security Both GIC's, whose returns are based on the performance
of the S&P 500, matured on Dec. 31, 2001.
Investor A had a total return of 43 per cent, reflecting a portion
of the market’s advance over the period. Investor B received
no return—he would have invested at the time when sky-high
markets were about to be dragged down by the collapsing technology
sector.
Wilson recommends staggering maturities over, say, five years—a
process called “laddering.” That way you don’t
have all your funds coming due at the same time. “It is important
for the investor to be disciplined in [his or her] approach to this
and not try to guess what interest rates are going to do over time,”
she says. This strategy ensures people remain invested at the five-year
rate, which is generally higher than the return on shorter maturities,
says Paul Lambe, a certified financial planner.
Money market funds
These highly liquid mutual funds invest in short-term securities,
such as Treasury bills, certificates of deposit and commercial paper.
With the upheaval’ in stock markets over the past year or
so, these have been very popular parking spots for investor cash.
In the 12-month period ended March 31, 2002, Canadian money market
funds returned 2.7 per cent on average. Over three years, the return
was 3.8 per cent.
Bond funds
The objective of this type of mutual fund is to provide stable income
with a minimal risk; bond funds invest in income-producing instruments,
such as corporate and government bonds. “The bottom line is
that they can offer income, cash preservation and growth potential,”
says Patricia Lovett-Reid, VP and managing director.
As of March 31, 2002, Canadian bond funds posted a one-year return
of 3.3 per cent; an average annual compound rate of return of 3.4
per cent over three years; and 5.3 per cent returns over five years.
Dividend funds
These mutual funds invest in dividend-paying preferred and common
shares, with the expectation of yielding a high level of income.
Overall, Lovett-Reid says, these funds were the most profitable
equity investment category in 2001. In the 12 months ended March
31, 2002, the funds returned an average of 8.6 per cent; the average
annual compound rate of return over three years was 10 per cent;
over five, it was 9.7 per cent.
“You have the [return composition comparable to] preferred
shares, but in this case you have a professional picking the stocks
for you. Also, dividend income is taxed at a much lower rate than
other types of investment income,” she says.
Preferred shares
Preferred shares are similar to common shares, but are usually issued
with a fixed dividend rate and have a prior claim over common shares
when it comes to dividends. In other words, dividends on preferred
shares must be paid before those on common shares.
If a company fails to make a preferred dividend payment, “the
dividend is usually accumulated and paid back at some future time,”
says Lovett-Reid.
As well, preferred shares have prior claim over common shares in
the event a company is wound down. In that case, preferred shareholders
and debtholders are paid first, before common stockholders.
Lovett-Reid says these shares are generally issued by large blue-chip
companies, and represent a fairly stable form of income. Of course,
performance ranges all over the map, depending on the issuer’s
quality and its payout policy. These days, top-quality preferreds
yield between five and nine per cent, she says.
Investment and income trusts
Investors earn income through holding units of a trust that invests
in tax-advantaged businesses. Although these investments can be
winners from a capital gains standpoint, they are designed to produce
steady cash flow. Payout rates are generally higher than GIC rates
and, depending on the underlying asset, provide an element of tax
deferral. The main types are oil and gas royalty trusts, real estate
investment trusts (REITs) and trusts that specialize in utilities
or other infrastructure. You can hold units in individual trusts
or in mutual funds that invest in trusts.
A royalty trust, for example, owns or partly owns an income-producing
asset, such as a mine or oilfield. This entitles it to receive royalty
income. These trusts generally receive tax benefits, which flow
to unitholders. REITs invest in income-producing properties such
as commercial real estate and shopping malls.
Short-term performance of many trusts has been solid. Average one-year
return of Canadian income trust mutual funds is about 16 per cent,
for example.
However, as Mastracci notes, “The high rates
of return for the past five years have occurred during a declining
interest rate period. This means that prices rise as interest rates
decline. Looking forward, we may well have a flat or rising interest
rate scenario. This means that the underlying stock values within
the income trust may stay flat or decline. So it could be the reverse
of what we’ve just had. The answer is to have sufficient diversification
so that no one investment vehicle unduly skews a portfolio.”
Although there is a broad range of products for income-seekers,
some of them may feel they have to expose a greater portion of their
portfolios to stock markets to get the return they desire. Others
may consider encroaching on capital to boost return. These can be
risky courses, however, given the threat of capital depletion over
the long haul.
Lovett-Reid says investment decisions should not be made solely
on today’s low-rate environment. Rates are bound to pop up
again, which should ease worried minds. She suggests a combination
of products as the best option for any income-seeker, depending
on risk tolerance, time horizon and liquidity needs. That means
diversifying across a variety of investments and asset classes.
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