We recently attended Blackrock’s “Rethinking Risk in a Changing World” workshop. The topics included Blackrock’s Global Market Outlook-Investment Opportunities and Risks, The Expanding Role of ETFs (exchange traded funds) in Portfolio Risk Management and an Institutional Approach to Risk Management. It was a very interesting and thought-provoking session.
We in the financial community borrow Nassim Taleb’s term “black swan event” to describe an unexpected event that can cause a major reaction, or volatility, in the financial markets. In the financial markets we talk about the volatility of a financial asset as a way to describe and measure the swings in valuation that can be expected in an investment. We tend to use this term to describe negative events that will cause a downward correction in the value of financial assets. But volatility swings both ways, and investors prefer up-volatility.
Blackrock’s Global Strategist, Kurt Reiman, had a very interesting take on black swan events and volatility. As he pointed out, the US stock market has just gone through a multiyear period where stock market returns have been above expectations with lower than expected volatility. In fact, the black swan event the financial community has been waiting for has occurred—it is just that the unexpected event was a positive one!
With that said, he continues to foresee stocks outperforming bonds in the coming year. From a Canadian perspective, he would continue to recommend a higher global exposure for equity portfolios, with Japan and Europe being better value than US equities. He continues to favour the short end of the bond market due to the negative impact rising rates will have on bond prices as this economic cycle matures. He believes that a US Federal Reserve increase in interest rates should not be feared as a sign that this economic cycle is overheating and coming to an end, but rather a positive sign that we are finally emerging from this economic malaise and reliance on zero interest rate policy. In fact, it has been over ten years since the US Federal Reserve has raised interest rates.
Assessing risk must be done from multiple angles, including the risk of being in or out of the financial markets. Rebalancing to your individual asset allocation plan, along with diversification, continue to be important tools for us to manage risk as we move through this, and future, economic cycles. You should see this reflected in your portfolio activity over the past year or so, and going forward in the near future.
We have had a “triple” in the annual portfolio returns of late. It has been “good times” in the world of equity investing, and annual bond yields also have been high, exceeding their yields-to-maturity. Lastly, much of the foreign investing component involves the US dollar, and it has appreciated, too. Below, we speak to each of these.
All snowbirds have been aware of the large and rapid jump in the US$ against our currency. The Canadian dollar was roughly at par in January 2013, and has gone more-or-less steadily down for the past 2 1/2 years. It has depreciated approx. 14% year-over-year to May 31st. While this hurts your US travel budget and purchase of US imports, you can “get even” by holding securities denominated in US$. The unrealized foreign exchange gain can add materially to portfolio returns. For instance, a recent Annual Report to April 30th posted an overall return of 9.79%, wherein 3.1% of that was exchange gain.
FIXED INCOME RETURNS
We rely on the fixed income component of our wealth to provide a combination of a) cash flow b) safety and c) stability.
Term deposits and GICs provide all of these:
- They pay interest on some regular, periodic basis
- Your principal is secure, subject to the limits of financial institution deposit insurance (CDIC)
- The value of the principal sum is constant throughout the investing period
Bonds are similar. “Semi-annual pay” bonds pay interest twice a year. However, their safety is driven by the underlying financial strength of the borrower. Federal and provincial government borrowers are generally considered to have zero risk of default, although in certain economic times, some investors have questioned the validity of this.
Bonds do not have the same stability of principal, however. On each monthly brokerage statement, the value of the bond is priced in the market-place, as if you were going to sell it. The market-place values your bond based upon the interest (“coupon”) rate that your bond pays relative to today’s available interest rate. When your bond was originally “born” (ie created by the borrower), the coupon rate for the life of the bond was set by the borrower to be competitive with the borrowing rates of the day. As time passes, market interest rates go up or down, whilst the coupon rate for that bond is locked in until it matures in the future. As an example, the graph below shows the history of annual returns for one particular provincial BC strip bond bought in 2005. The blue line reflects the ups-and-downs as the prevailing market interest rates move. The flat red line is the yield-to-maturity guaranteed at the purchase date for the life of the bond.
Yield-to-Maturity vs. Yearly Returns
If your coupon rate is higher than the current interest rate, then your bond is “attractive”, and it is priced accordingly at a “premium”…meaning more than you originally paid for it. Thus, at that point in time, you hold an unrealized gain on that bond. The same applies in reverse, when your bond is not attractive and is priced at a “discount”. And so, the market price of your bond varies throughout the period that you own it. When the maturity date arrives, you are guaranteed to receive “par” value from the borrower, regardless of what the market says; in fact, the market recognizes this and ultimately values the bond at its par value on the day of maturity. Thus, any temporal unrealized gains you enjoyed in the past will, by definition, evaporate to zero when the bond matures at par.
This is what we are seeing right now, as depicted in the graph below, which shows the one-year market returns to March 31st and yield-to-maturity (vertical scale) for each of the holdings in a real, sample portfolio (horizontal scale). The one-year market returns are the steep line. You also will see how those returns rise for the age of maturities (in this example, only a six year maturity span).
The average yield-to-maturity of that entire portfolio of bonds is 4.81%, but the average current one-year return is 6.72%; thus, a temporal unrealized gain! This temporal gain will evaporate to zero as each bond matures in turn…. and that means that today’s temporal gains will become tomorrow’s temporal losses year-by-year as each bond gravitates to par at its respective maturity date. You might observe that the appreciated bonds should be sold now to secure their unrealized gains. Not so simple! You then would be buying new bonds which have present-day low yields-to-maturity!
The low interest rate environment for replacing maturing fixed income has evoked groans from investors. Bonds are maturing off the top of the time ladder with yields of, say 4 1/2%, and being replaced at the bottom of a ten-year ladder earning 1.7%.
As we have written previously, our response to redeploying maturing fixed income has been multi-fold, and depends upon the individual circumstance. In some cases, we have been buying what we refer to as “alternative debt” (“Alt-D”) instruments. They are “alternative” in that they carry some, but not all, of the characteristics that we seek in our fixed income portfolio. Principally, we are adding two kinds of Alt-D: preferred shares and inflation-protected. Most preferred shares are issued by the Canadian banks. They carry a good cash yield and—bonus!- dividend tax credits, which raise the after-tax yield (in non-sheltered accounts). One of the textbook problems with preferreds is that they carry a provision whereby the issuer can redeem them, leaving the investor back in the world of seeking re-deployment of the cash proceeds. Indeed, this is exactly what has been happening – there have been redemptions by banks over the past quarter. We can mitigate this by buying a Preferred ETF, which holds a basket of such preferreds. While one bank may redeem, most of the portfolio in the ETF remains intact; thereby being more “stable”.
We also have been buying “TIPs”, which is a US$-denominated basket of bonds which carry an inflation-adjustment rider. Its return is the market return plus-or-minus foreign exchange. To April 30th, for instance, the market gain was 2.33% and the exchange gain was 10.69%. We also are buying an inflation-adjustment instrument (XRB) which is purely Canadian, and thus takes out the “foreign exchange ride”.
It has been a broad-reach uptick in equity investing. In the review of all equity holdings, very few have performed poorly. Most have performed satisfactorily-to-very-well.
We provided our Annual Sector survey in the Spring edition. In summary, outside Canadian borders, health, technology and utilities were the top three. We actively have been taking some of these profits off the table, mostly by selling the Global health and tech ETFs and also the biotech ETF, “IBB”. The “losers” of the period are mostly related to the Canadian resource industry, which was impacted by the recent dramatic drop in oil prices. This captures all Canadian energy stocks as well as related ETF baskets, like “XEG” and “XMD”. We have pursued the oil drop in recent months by buying an ETF (“USO”) which simply owns barrels of oil. This is a USD security, so it includes a foreign exchange component. Its market return has been 10.3% in the four months, and 26.8% in the two months, to May 31st. We have been monitoring Horizon’s NYMEX Crude Oil ETF, which is hedged to the Canadian dollar as a way to be exposed to the commodity in our home currency. Currently the fund is too small for us to invest comfortably. However, once it reaches a critical mass where we are not concerned about liquidity, we will add it to our list.
A common holding, the iShares Canadian Select Dividend Index ETF (XDV), has been underperforming the iShares TSX 60 (XIU) and the TSX Composite Index over the last 12 months on a price performance basis. This underperformance has been somewhat surprising, given investors’ current appetite for yield and XDV’s superior dividend distribution yield of 4.1% as compared to XIU’s dividend distribution yield of 2.7%. Under the hood, XDV has significantly higher weightings than XIU in the Financial Services and Utilities Sectors and is underweight in the Healthcare, Technology and Resources Sectors. XDV is heavily overweight in the Oil Services Sector which has been particularly hard hit with the current downturn in oil prices. Over the medium and longer term, XDV has had comparable share price performance to XIU and to the overall TSX Composite Index, while providing a superior yield. We will continue to use both XDV and XIU when an asset allocation plan calls for the purchase of Canadian equity: which one we use will be dependent upon the portfolio’s current industry sector weights and which ETF best fills the gap in the industry sector weightings we are trying to achieve at that time.
Gold’s meteoric rise to US $1870 per ounce in 2011 seems a distant memory with today’s price languishing at just under US $1200. Particularly perplexing was that, recently, gold sold off slightly on a day that the possibility of a Greek exit from the Eurozone had global stock markets tumbling. Gold is an asset that has relatively long periods of price stagnation followed by very substantial increases over relatively short periods of time: as witnessed in the period 1978 through 1982 when gold shot up from US $140 to US $690 per ounce, or as mentioned above, more recently in the 2008-2011 bull run. Coincidently both of these periods were a bear market for stocks. Quite frankly, we hold gold hoping it will do nothing for the portfolio! But when gold is on one of its runs, we will be happy we own some in the portfolio.