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Quest for yield ratchets up the risks

Fixed-income ETFs take off in popularity, but investors should watch their exposure to junk bonds

Special to The Globe and Mail

For investors who are dependent on returns from fixed income vehicles, the past few years have not been kind. Interest rates bump along at historic lows, and safe investments such as guaranteed investment certificates and government bonds offer returns so low they have trouble keeping pace with inflation.

Investors are scrambling for alternatives, and the financial services industry is creating new products and dusting off old ones.

"Definitely one of the main themes right now in the investing world is finding income," says Mark Raes, a Toronto-based portfolio manager with Bank of Montreal Asset Management.

Fixed income assets in a portfolio accomplish two very different things. Sure, they provide a steady income stream, but they also serve as a low-correlation counterweight to equities.

To eke out a bit more income from their portfolios, investors are moving money into high yield bonds - below-investment-grade bonds that used to be called junk - and emerging-market bond funds, Mr. Raes says.

BMO and its competitors have made the shift into the first category easier by creating high-yield-bond exchange traded funds (ETF). BMO's ETF trades with the ticker ZHY on the Toronto Stock Exchange. "That gives people a lot more yield, about 6.5 per cent yield to maturity before fees," Mr. Raes says.

The race for yield on the part of investors, and the popularity of options such as high-yield ETFs, have depressed yields to historic lows and pushed prices up to historic highs, says Michael Cooke, the Toronto-based head of distribution for PowerShares Canada. "Investors need to pay closer attention to what they are considering and what they are getting when they look at these alternative income sources."

He sees a policy on the part of central banks to force people to take on more risk, which is "just not an option" for retirees or those near retirement. Investors are going to add more risk no matter what they do in search of yield, however. Buying longer dated bonds adds interest rate risk - rates eventually will start marching back up - and moving down the credit quality ladder with corporate bonds increases issuer risk.

The low-interest-rate, low-inflation environment could linger a lot longer than most people think, Mr. Cooke says. That influences how PowerShares assembles its fixed income ETFs, mixing in high-yield bonds and emerging-market sovereign debt with more traditional government bonds and investment-grade corporate bonds such as with its PowerShares Tactical Bond ETF (ticker symbol PTB). That fund is subject to tactical and strategic asset allocation, meaning managers actively increase or decrease exposure to markets and sectors.

ETFs have come to the forefront because they offer a low-cost way to obtain yield and spread risk. Cost matters a lot more in a low-interest, low-yield world than in the days when government bonds paid returns in the high single digits.

The good news is the industry has worked furiously to develop fixed income investment platforms. But that is also the bad news.

"Despite the fact that there are now 550 exchange traded funds globally that allow you to slice and dice the bond market any which way you choose, having all that choice hasn't necessarily eased the burden for either financial professionals or investors in navigating the uncertainty of this interest rate environment," Mr. Cooke says.

Fixed income ETFs make up one of the fastest growing components of the ETF sector, accounting for about 40 cents of every dollar invested, Mr. Cooke says. "I think this is more of a secular trend. It is not just risk aversion, and it has become incumbent on asset managers [and] ETF providers to find ways to help investors navigate through these uncertain times. ETFs have become a very compelling vehicle for doing that."

The quest for yield as well as stability can be seen throughout the market, says James Price, the Toronto-based director of fixed income with Macquarie Private Wealth.

"The securities that pay what are deemed to be sustainable dividends, even if they are not fixed, have been bid up a whole lot" while stocks of companies that do not pay dividends have suffered. Those dividend-paying equities "weren't in vogue earlier in the decade, now they are making a huge comeback."

Mr. Price says there is some concern the "steady march down the quality ladder" of fixed income investment could result in more investors giving up on the safety of being a bondholder for being more of a stock holder, with less security should companies fail. Given how many investors overreacted to the market crash of 2008-09 and loaded up on fixed income investments and held more cash, however, investing in a greater percentage of equities is not necessarily a bad thing, he says.

"People are normalizing the risk that they are taking and I don't think that is unhealthy. I think that is pretty normal," Mr. Price says. "Where it gets dangerous is when investors who shouldn't really be taking the risk are starting to stretch in order to get the income that they need."

Those people, near retirement or in retirement, do not have the time necessary to rebuild their investment capital base should they lose any of it in a market downturn.

© 2007 The Globe and Mail. All rights reserved.

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