Generally, the investment world can be split into two mainstream terms — stocks and bonds.
Investors typically split their money between these two based on their goals, knowledge and comfort. Some of our clients are 100 per cent in bonds (or guaranteed equivalents), while others are 100 per cent in stocks. However, most investors fall somewhere in the middle, which we commonly refer to as a balanced investor.
Over the last 12 months, the Bank of Canada (BoC) has raised interest rates five times. There are several types of bonds. The least risky and often used as a benchmark are AAA-rated Government of Canada bonds.
According to Thompson Reuters, their values at the time of this writing were:
• one-year: 2.10 per cent
• five-year: 2.38 per cent
• 10-year: 2.45 per cent
Here are two quick observations. Despite rates rising, bond rates are still incredibly low, making it a challenge to create a sustainable retirement income. Second, when rates go up, the price of a bond falls. In a simplistic illustration, if the 10-year government bond was two per cent and rises to three per cent, that results in an extra one per cent interest each of the 10 years. Theoretically, existing bonds issued at two per cent would drop roughly 10 per cent in price to make up for this shortfall.
We have always been a fan of James Bond movies and, over the years, there have been many actors that have played the role of 007. As an investor, there are a few substitutes for bonds as well. Among our favourites are preferred shares and mortgages.
Preferred shares (prefs) are similar to bonds because they are guaranteed by the company and pay a fixed rate of return; however, they pay dividends in lieu of interest, making them incredibly tax efficient as per table:
In addition, preferred shares typically pay a higher rate of return. Currently, many investment grade prefs pay close to five per cent. For example, Enbridge five-year bond (06/30/23) pays 3.57 per cent, Enbridge five-year pref (ENB.i) pays 5.1 per cent, Bank of Nova Scotia five-year bond (04/17/23) pays 3.15 per cent and Bank of Nova Scotia pref (BNS.i) pays 4.85 per cent.
Not only do investors get 40 to 50 per cent more yield with preferred shares, they also get a major tax break. For example, a retiree earning $45,000 a year before tax in dividends will actually get money back from the dividends. This is due to the Canadian dividend tax credit.
Looked at another way, an investor would have to earn about 1.3 times more from a bond to end up with the same after tax result. In the above example, a five per cent preferred would be equivalent to a 6.5 per cent bond. It is worth noting that preferred shares tend to carry slightly more risk because bonds rank ahead of them in the event of a default. In addition, prefs trade on the stock exchange which is subject to investor emotion and liquidity events.
When we think of mortgages, we often think of buying a home with the help of a mortgage that takes most of our working years to payback. As an investor, we can flip this around so we are the ones being paid (ie: mortgage holder). Essentially, investors pool their monies together and hire a manager to invest into several mortgages. There are several types of mortgages: residential, commercial, development, etc. All carrying different levels of risk and return. Currently, yields to investors range between four and seven per cent, depending on the risk and terms accepted.
If an investor decided to use prefs and mortgages, they should be placed in the most appropriate account. Prefs are best located in non-registered and corporate accounts to take advantage of the Canadian tax credit. Whereas mortgages are best located in tax sheltered plans like RSP, RIF, RESPs and TFSAs.
As always, please consult a professional before making any investments.
Until next time, invest well, live well.
This document was prepared by Eric Davis, vice-president, portfolio manager and investment advisor, and Keith Davis, investment advisor, for informational purposes only and is subject to change. The contents of this document are not endorsed by TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc.-Member of the Canadian Investor Protection Fund. All insurance products and services are offered by life licensed advisors of TD Waterhouse Insurance Services Inc., a member of TD Bank Group. For more information, call 250-314-5124 or email Keith.firstname.lastname@example.org.