By: Kate McCaffery
Advisor.ca
Tuesday, February 22, 2005
Now is probably not the time to go bargain hunting in the bond market. Although no one knows for sure when Alan Greenspan is going to hike interest rates, the talk coming from central bankers suggests promise of slightly higher returns in the future.
Adrian Mastracci, investment counsel at Vancouver’s ‘fee-only’ KCM Wealth Management, says, "The key to a ladder is once you put it in place, once you're running on it, everything that comes due gets reinvested for five years.”
Eric Levesque, chief strategist for North American, foreign exchange and fixed income research at TD Securities says most signs point to rates headed higher in the next year or two.
"I have a lot of trouble seeing how in this kind of environment you can get short ends remaining this low," he says. "That said, a lot of factors — namely chatter on issues like U.S. pension reform, and Asian central bankers buying U.S. debt — are going to keep yields below what they normally would be at this stage of the cycle."
By the end of 2005 he says 10-year U.S. bond yields could be at 4.85%, and Canada will probably outperform the U.S., but Canadian corporate spreads could remain tight for a while.
"I would say go short duration for now," he says. "In general the long end, even though it's less the case in Canada, the long end yields are still extremely low." This in turn means long term bond prices are relatively high.
At Desjardins Securities, Peter Gibson, head of strategy and quantitative research puts interest rates around 3% by the end of the year. "I think interest rates will generally stay below the 4.5% level on the 10-year U.S. treasury and I think they're going to go even lower next year," he says. "My argument is that the 10-year U.S. treasury will be as low as 3.5% at some time in 2006."
Although in past years he's argued that 10-year bond yields might go as low as 2.7%, Gibson says, currently, the yield is backing up a little. Currently the Canadian and U.S. 10-year bond yields are at 4.24% and 4.28% respectively (as of February 22, 2005).
"We think that probably in 2006 you're going to see an average bond yield of 3.9%. You'll see 3.5% at a low with a back up around 4.5%." If yields do climb that high, Gibson says it will happen early in the year, probably before the summer. "If it got as high as 4.5% then I would probably start getting very aggressive on my bond exposure."
But timing the bond market probably is not going to be worth the stress it creates even if fixed income clients might find current rates a little hard to swallow. Strategies like bond laddering can help meet fixed income needs in a client's portfolio and provide a predictable schedule of earnings coming from their fixed income investments, while still ensuring sufficient liquidity to take advantage of higher rates in the future.
The concept is simple: after determining how much of the client's fixed income assets belong in the structure, divide the amount into four or five equal parts and invest each amount in bonds with progressively longer maturity dates. As the instruments come to term, roll the assets over into new investments to mature further along in the ladder.
For example, a client with $5,000 can invest $1,000 each year in bonds with annual maturities. The first amount allocated to the bond ladder is invested in a product with a one year maturity. When the investment comes to term, the assets are then reinvested in a five year product that comes due in year six. Similarly, the following year the client's initial investment with a two-year maturity date is reinvested in a product with a five year term, scheduled to mature in year seven. Eventually, the client will hold a number of five year products with rolling maturity dates.
"The key to a ladder is once you put it in place, once you're running on it, everything that comes due gets reinvested for five years," says Adrian Mastracci, investment counselor at Vancouver based KCM Wealth Management.
Mastracci predicts interest rates between 3.5% and 4% in the next two or three years. "The short end is going to move up a lot more than the long end. The five and 10 year rates are not going to move up as much, maybe another 1% from where they are now," he says. "There's going to be a move up, the question is when. I don't know when. That's why I do a bond ladder over the next 4-5 years."
MFDA planner Ryan Beebe doesn't use the bond laddering strategy with clients, but agrees the structure is good for people who need guarantees, provided they don't have an immediate need for the cash flow. "Like anything else, it's another strategy," he says. "It may not work for 50 people, but it might for the next one who comes in."
Bond funds are good for a lot of clients, but the ladder structure works well for others, particularly those who are sensitive about fees, or those who prefer to have more stability in their fixed income assets.
"Bond funds are OK for some people, but most of my clients want more predictable income from certain sources," says Mastracci. "My allocation within a bond fund is something that I have no control over. Once you're on the ladder you know what you're paying for and you know what you're going to get. There's less of a question mark about what you will have at the time the maturity comes along."
The fee-only planner says a bond ladder might make up 20% of a client's fixed income portfolio of domestic and foreign bonds, dividends and GICs. Currently he is building four year bond ladders, anticipating higher rates of interest going forward. Although it is possible to shorten the ladder to three years, he says the structure is probably not long enough to capture the upside if interest rates recover.
"You could build it for three years, but that's getting into the too short area. One year is definitely too short," he says. "Besides, I don't think all the upside is going to be in the next year. I don't think it's going to be in the next two years either. Maybe in three, good chance of it in four and certainly in five. That's the way I look at it."
Rather than trading bonds, which he says will probably result in a capital loss given current low rates, he tends to use strip bonds with predictable maturity amounts. Strip bonds are long term bonds with the annual interest payments or coupons, taken out of the investment and traded separately at a discount to the par or face value due at maturity.
"They're very simple instruments. They're not the sexiest thing on earth, far from it, but they do work very well."
|
