Secure Income in a Dangerous World

With the turmoil afflicting global financial markets, investors are
being driven to consider traditional refuges, like guaranteed
investment certificates, money market funds, and government bonds. In
seeking safety, they face the reality that interest rates on truly
safe investments are minimal. What options do they have in a world
where safe returns are approaching zero?
Day after day, I hear from investors seeking yield on their money,
without the risk of the market. This struggle is not new.
Traditionally, little risk free return has been available beyond the
rate of inflation, especially in taxable accounts. In the heady
interest rate environments of the eighties, double digit interest
rates were offset by similar inflation levels. The nineties, and
pre-crash days of this decade, saw both inflation, and interest rates,
decline in a fairly uniform fashion. However, the lack of any real
return never seemed so bleak as it does in a world with near zero
inflation, and miniscule interest rates on guaranteed investments.
Why is it different today?
Quite simply, "real" rate of return is more of a concept for advisors
than investors. In theory, real return only occurs when the after tax
income exceeds inflation. In practice, getting twelve percent, and
losing eight percent to inflation results in cashflow, as the impact
of inflation occurs in the future. If tax rates were 33%, the "real"
return is zero. If interest rates and inflation both drop in half, in
the theoretical world of "real" return, income levels have not
changed. If an investor had invested a million dollars, and their
income dropped from 120,000 to 60,000 per year, they would not agree
that their "real" income was unchanged, regardless of theory.
This drop in cashflow from safer investments has driven investment
behaviour in past. The explosion in mutual funds during the nineties
was driven, in part, by "GIC Refugees," a group accustomed to high
guaranteed yield, who chased equity and bond funds when guaranteed
rates fell. This worked out well during the bull market of the
nineties; in fact, it may have contributed to it. The decade long
bear market has shown the risk of using equities to generate cashflow.
Many portfolios have been decimated by systematic withdrawal plans
over the past few years.
The situation sounds bleak. Many investors are surprised to discover
that this is a fantastic time to find relatively safe income. A
number of options have emerged, which offer significantly higher
relative yields than the "safe' investments, which are guaranteed to
erode capital, given their near zero real returns.
First, the world of bonds has changed dramatically. Only a couple
years ago, little extra yield could be found with even a weaker
investment grade bond. After commissions, it was pretty difficult to
make a case for buying an investment grade bond over a guaranteed
certificate. Spreads of less than half a percent over government
bonds were very common. In a world where there was no real yield
after inflation, investors actually chose to take on corporate risk
for very little extra return. As I said, this world has changed.
After shocks to the system like the collapse of Lehman, debt has been
repriced. Reality is that near record spreads exist between bonds and
guaranteed certificates, and an investor may achieve several extra
percent by simply buying the bonds of their bank, instead of its
guaranteed certificates. Tier one and two capital of Canadian banks
has offered yields nearing double digits, while GIC rates have hovered
near two or three percent. Many investors are choosing managed money,
instead of trying to select individual bonds. Corporate bond mutual
funds are actually able to deliver extra yield, even after their
management expenses.
The outstanding yield on Canadian bank bonds is not the only
opportunity presented by the rising cost of their capital.
Traditionally, Canada's big banks have paid low dividend yields on
perpetual preferred shares. These shares would offer yields near the
level of thirty year Canada bonds, and were sold to security concious
investors who liked the tax treatment of their dividends. This
allowed Canadian banks to broaden their equity based using what was
essentially debt like equity. This easy and profitable leverage has
become much more expensive, to the benefit of security concious
investors. Recently, the trend in preferred shares has been to issue
five year rate reset shares. The most recent series have offered
yields of over six percent, with a reset, at the institutions' option,
to over four percent above the yield on five year Canada bonds. These
yields are spectacular, especially with the tax treatment afforded to
dividends. Preferred shares should not be bought without forethought,
or advice. The perpetual shares issued over the past few years have
generally fallen in value, particularly as the credit market has
seized up. Normally, falling interest rates should have driven up the
price of the existing shares, but the loss of confidence in global
financial institutions has kept their price depressed, and the yields
are pretty spectacular on some series of financial preferred shares.
The risk is that interest rates may rise, and keep prices depressed,
even as credit conditions normalize.
Another emerging option is the use of guaranteed withdrawal benefit
plans, or GWBs. These are issued by insurance companies, and are
essentially a mutual fund with an annuity guarantee attached. Most
offer exposure to top mutual fund families, allowing you to purchase
equities, albeit frequently at high management costs. The annuity
guarantee typically kicks in at age sixty-five, and each version
offers a guaranteed growth rate prior to retirement, and a fixed
income for life. The nuances are complex, but the premise is simple;
you put in a lump sum, and receive an income for life, guaranteed.
Finally, the traditional annuity option seems to be emerging from the
shadows. Many advisors are using a combination of an insurance
contract and an annuity to generate guaranteed, lifetime income. This
option is intriguing, but should not be considered lightly, as it is a
lifetime commitment. It works best in taxable accounts, as it
capitalizes on the highly tax friendly treatment of prescribed
annuities.
There are numerous options, and a security concious investor should
seek the help of a professional advisor before choosing any of these
solutions. In general, the best solution will involve two or more of
these options. The key is that interest rates are at record low
levels, but an investor and his advisor may construct a tax efficient,
stable, and relatively secure stream of income, even in this dangerous
financial world.