Last year, the loonie’s depreciation of 14% against the US$ contributed a positive rate-of-return to portfolios holding investments out of Canada and marked in US currency. This continued and accelerated through January 2016, but the loonie has recovered 7% since then. Year-over-year to May 2016, the loonie declined 5%, giving a much smaller lift to portfolio returns this year than the 14% of last year. Foreign exchange gains delivered approx. 4 1/2% (one third to one half) of the annual returns in the Spring of 2015. This Spring, they delivered approx. 1%.
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 of overall portfolio returns. The relative contribution of fixed income has shifted over the years. Higher bond yields in the past have delivered higher cash flow, but today’s yields approximate only 1–1 1/2%. So, we have had to shift our appreciation of fixed income to safety and stability, and seek cash flow (if called for) from elsewhere in our portfolios.
We have written extensively in our Foresight Library on bond investing. The following graph is a one-year update to the information we presented in the Summer 2015 Foresight issue.
The middle horizontal line represents the yield-to-maturity for a sampling of bonds of varying maturities that were purchased many years ago in a real portfolio. The steep vertical line shows last year’s one-year yield on each of those bonds. The lower horizontal line has been added this year to show this year’s one-year yield on those same bonds. The average yield-to-maturity on that entire portfolio of bonds is 4.81%, but the 2016 one year return was 0.98%, compared to 6.72% a year ago. As we said last year: “today’s temporal gains will become tomorrow’s temporal losses as each bond gravitates to par at its respective maturity date”…. and more of this lies ahead.
We also wrote last year about alternative debt (“Alt D”) instruments. As interest rates have declined to almost zero levels, many in the investment community have gone in search of increased yield through either a) increasing their bond portfolio’s duration (the average maturity of their bond portfolio) or b) increasing the credit risk of the portfolio through increased exposure to high yield corporate bonds or c) adding preferred shares.
The Canadian preferred share market has not been the solution to low interest rate bonds that many had hoped for, as preferred shares with automatic dividend yield resets dropped for the next five years to levels far below what the market was expecting a few short years ago. As a result, in early 2016, preferred share prices were down approximately 35% from mid-2013 levels, and the preferred share ETF was down 16% for the year ending March 31st, 2016. For those investors who put their entire portfolio’s fixed income allocation into these preferred shares, it will be many years before the increased yield on the preferred shares over the low current bond yields will cover this capital loss.
Our fixed income strategy through this low interest rate environment embraces Alt D; however, we cap it at only 10-15% of the fixed income portfolio. Thus, our exposure to the preferred share capital loss above was minimized through 2016.
Last year at this time, we were carrying fixed income positions in TIPs, a US$-denominated real return bond. Its return is the market return, with an inflation-adjustment rider, plus-or-minus foreign exchange. The market return over the year was slightly negative, but the exchange gain, as discussed above, was significant. Thus, last February, we chose to clear all of our TIPs positions to lock in that exchange gain. Typically, this yielded a 7% return for the year. These proceeds of TIPs were redeployed account-by-account based upon the asset allocation call in each case, which varied across the board.
We recently attended a Blackrock conference on Fixed Income Exchange Traded Funds. The market’s adoption of fixed income ETFs is somewhat behind their equity counterparts. Bond ETFs are less than 1% of the overall global bond market; however, they are gaining ground very quickly. There are now over 900 Bond ETFs globally, totaling over US$560 billion in assets, compared to just 14 Bond ETFs in 2003 totaling US$ 6 billion in assets. Historically bond market pricing has been done over the counter with bond trading desks in a verbal bid/ask marketplace. But bond ETFs, which are traded on stock exchanges, are bringing bond pricing into an open and clear marketplace that brings with it competitive price discovery. Your portfolios at AFT Trivest are slightly ahead of the global adoption curve, with bond ETFs comprising approximately 15% of our fixed income portfolios. We are currently using three government bond ETFs within the regular part of the bond portfolio. The iShares 1-to-5 year Laddered Government Bond ETF is a portfolio of Canadian government bonds maturing each year for the next five years. As bonds in the ETF mature, they are reinvested in new bonds that will mature five years out. The iShares Canadian Real Rate of Return Bond Index ETF is a portfolio of Canadian government bonds that provide an inflation-adjusted income stream. This bond portfolio is designed to protect against the negative effects of inflation on a standard bond portfolio. The iShares Floating Rate Index ETF is a portfolio of Canadian government bonds whose interest rates adjust to reflect changes in interest rates. This ETF is used to manage interest rate risk. The benefit of these three bond ETFs is that they can efficiently diversify relatively small, to very large, amounts of cash called to fixed income. They also provide a very low cost and efficient way to fund cash calls or to rebalance the portfolio when the asset allocation plan calls for the sell down of fixed income to be re-allocated to equities.
Global equity markets started 2016 under a great deal of pressure and were completely opposite to the strength we saw in the first six weeks of 2015. By mid-February this year, global equity markets were off 10% to 25% from their yearend 2015 levels. However, since the mid-February lows, we have seen significant strength in equity prices, with Canadian equities leading the global rally. In Canadian dollars the TSX 60 is up 20%, US S&P 500 is up 17%, Europe is up 17%, Japan has rallied 19% while the Emerging Markets are lagging, up only 9% off the February lows. All impressive rallies! However they are eclipsed by the 49% rally that the Canadian oil & gas sector has delivered after its crippling collapse in 2015. This sector is not out of the woods yet and there is a long way to go before we return to the price levels of late 2014, before the collapse in oil prices.
As share prices plummeted on lower oil prices amidst the wide spread forecasts for the continued and long term collapse in oil prices (especially when it broke US$30 a barrel WTI), we continued to buy oil stocks, as their underperformance resulted in their being underweight in our target weightings for that industry. With oil rallying back to US$50 a barrel WTI, and the almost 50% lift in oil and gas stock prices, we are now seeing an overweight position in this industry sector and have been selling down oil and gas stocks to bring them back into line with our target weightings. Not surprisingly, now that oil is back to almost US $50 a barrel we no longer are seeing widespread forecasts for oil to hit US$ 20 a barrel! Buying low is never an easy exercise because the asset class that is priced low is there because the market is very pessimistic about its prospects.
We provided our 2015 Annual Sector survey in the Spring edition (available on our website). Updated industry sector leaders for the first half of 2016 were:
Aside from the energy sector’s rebound with rising oil prices after a devastating year, the industry sector leadership of utilities, telecommunications and consumer staples reflects a very defensive stance by global investors…. and a very cautious view towards global growth prospects in the coming quarters. With corporate earnings forecasts for the 2nd quarter of 2016 being revised downward in recent weeks, the market may well be positively surprised that the corporate earnings environment is not as soft as feared. With investor expectations lowered, and corporate dividends higher than corresponding 10 year government bond yields in all the major regions globally, we continue to expect modest positive returns for stocks in the coming year. We also continue to expect market volatility to be a “headline factor” as this long term secular bull market matures. For a more complete review of rebalancing your portfolios, please see our Portfolio Rebalancing video on our YouTube channel.