By Jonathan Chevreau National Post FP Money Saturday, July 19, 2003

This week's surprise rate cut was another shock to retirees and near-retirees trying to live on fixed incomes.

Anyone rolling over GICs or strip bonds with staggered maturities is well acquainted with reinvestment "sticker shock."

The 0.25% drop in interest rates surprised most economists, but that's been the general direction for the past three years.

Back on July 6, 2000, five-year Guaranteed Investment Certificates paid 5.55%. On July 7, 2003 they paid less than half that, or 2.8%, says Adrian Mastracci, of Vancouver-based KCM Wealth Management.

The traditional strategy of "laddering" maturities won't help much in this environment, says Gordon Pape, publisher of a new newsletter, The Income Investor. The difference between one-year and five-year rates is less than 1%.

Thus, one-year GICs now pay 1.9% instead of 5%, and three-year GICs 2.35% rather than 5.3%. Those with strip ladders will experience the same phenomenon, although strips pay slightly more.

A natural response to this dilemma is to seek higher yields by taking on more risk. But this may catch investors in a vicious circle. As yield-hungry retirees take more risks they increase the chances of incurring losses which will chip away at their retirement nest eggs, Mastracci says. Little wonder some are rethinking their retirement plans or putting them on hold.

Jim Rogers agrees things are getting "tougher for investors who want income and security of capital through the same investment vehicle."

If you think Canadian retirees are being squeezed, it's worse in the United States, where rates are at 45-year lows of 1%. There, Federal Reserve chairman Alan Greenspan seems bent on making cash trash and rewarding risk in the stock market.

Donald Coxe notes the Bush administration's move to drop dividend taxes means U.S. investors will do 300% to 400% better with dividend income than cash. Meanwhile, seniors who prudently put aside cash for a rainy day are forced to live in "genteel poverty" on the negligible income paid by treasury bills or money market funds. The gap between dividend and interest income is less dramatic in Canada, although our tax treatment on dividends and preferred shares is superior to interest income.

Andy Filipiuk suggests investors resist the central banks' blandishments and do the opposite. "If policy makers won't pay you a return on cash and want you to spend it or take more risk, I'll save my money and keep it in cash. We will likely have an opportunity to buy something a lot cheaper or with a higher yield a year out."

Even after the rate cut, Canadian interest rates are far higher than U.S. ones, which is why foreigners are buying our bonds. There's also more room for our rates to fall, which means bond prices here could still rise. By contrast, U.S. rates have little room to fall. If they start rising, it will hurt bond investors.

Subscribers to Richard Russell's Dow Theory Letters were shocked this week when the veteran analyst revealed he sold off the remaining bonds in his personal portfolio. He now holds only short-term treasury bills and gold. "I think the big bull market in bonds is over," Russell told baffled subscribers.

However, yield-starved Canadian investors have an alternative: income trusts. These should be viewed as tax-efficient high-yielding equities. They are a new recommendation for Rogers, who usually suggests seniors use a mix of laddered bonds, GICs and balanced mutual funds. Given the explosive growth in income trusts, Rogers advises due diligence.

If interest rates do rise, income trusts or bond funds may be no panacea. Yields have already fallen on income trusts. Energy trusts can yield 12%, but are too volatile for some investors. Pape recommends income trusts with lower yields but less risk and more stability. Those willing to make the risk/return trade-off can consider corporate or "high-yield" bonds or funds.

Those worried inflation may return should consider Real Return Bonds (RBBs) as long as yields are 3%, says Dan Hallett. RRBs provide a basic yield plus a kicker linked to inflation.

Filipiuk won't touch income trusts or corporate bonds, but is also a believer in RRBs. They are the only bonds he'll commit to long terms -- otherwise, he won't go beyond seven-year terms. He's happy with treasury bills or savings bonds. He also likes precious metals funds, but keeps clients limited to 3% to 5% of a total portfolio.

Warren Baldwin suggests first or second mortgages as alternatives to GICs or bonds. "Mortgages have their own special risk issues, such as equity ratio and debt service ratio. Mortgages are not for the faint-of-heart and can have some shocking problems for an investor more familiar with government bonds or GICs," Baldwin cautions.

Investors should always practice proper "asset location," putting cash-like investments in RRSPs and RRIFs, and dividends, capital gains and tax-efficient income trusts in taxable portfolios.

NOTE: The information provided above is intended for general informational purposes only. It does not constitute advice for anyone's specific situation. Everyone should always first consult directly with their advisors to determine the appropriateness of any information contained above before taking any action. KCM Wealth Management Inc. assumes no responsibility for any loss or damage arising from the use of, or reliance upon the above information.