I was recently warned by someone in the financial sector that it’s not a great time to invest in bond ETFs. My current asset allocation is 60% equities and 40% bonds, so I’m wondering what alternatives would you suggest for that 40% portion of my balanced portfolio?
At first I considered real estate income trust (REIT) ETFs, but read they should be considered equity investments. Then I thought about mortgage-backed security (MBS) ETFs. but there seems to be only one in Canada (ZMBS) and its performance doesn’t seem all that impressive.
I’m kind of at a standstill as I decide how to invest that 40%. Thanks for any advice you can share.
I’d love to know why you were advised against investing in bonds right now, Fred. If I had to guess, I suspect you were told one or both of the following:
- Interest rates are so low that you’re not going to make any money on bonds, especially after inflation is taken into account;
- Interest rates are going to rise and, when they do, bonds will drop in value.
But these points—and any possible alternatives to bonds—can’t be considered without first understanding the reasons why you originally chose a balanced portfolio to include bonds. (When I talk about risk here, I mean volatility—or how much your portfolio may fluctuate year to year. Other wealth building risks include inflation, taxes, and human behaviour.) Here are a few reasons you may be holding bonds:
- Bonds are safer than stocks.
- Bonds reduce portfolio risk.
- Bonds add diversification to your portfolio.
Let’s take a look at each of these reasons why investors hold bonds and what other investments, if any, would satisfy the same purpose.
Bonds are safer than stocks
I know some will argue that in the long run stocks are a safer bet, but not from a volatility point of view. In any given year your stock portfolio could drop 40% to 50%. That risk never goes away.
As such, many investors hold bonds because they anticipate they’ll need to draw money from their investments within the next few years, and they need to protect against that volatility.
If that’s the case for you, Fred, good bond replacements would be cash, high-interest savings accounts (HISAs), or maybe a guaranteed investment certificate (GIC), if your need for the money is a year or two down the road. Ideally, you want no volatility and easy accessibility. (Here MoneySense’s lists of the best HISAs and best GICs in Canada right now.)
Bonds reduce portfolio risk
Equities have historically provided higher rates of return than bonds over the long term. (You can see for yourself using this calculator, although there is no guarantee that what happened in the past will happen in the future.)
The challenge for some investors, however, is tolerating short-term volatility and staying invested—even when the equity portion of their portfolio drops 30% or more. Can you stay the course? Say, when the news is predicting it’s going to get worse, your neighbours tell you they got out, and social media explains why a doomsday event is nigh or that you should switch to some investment you’ve never heard of.
Many investors, therefore, hold bonds to reduce their portfolio’s volatility overall, which can help them overcome the feeling of needing to sell when markets drop.
If you fall into this camp, Fred, appropriate bond alternatives may include assets that provide an income such as preferred shares, dividend stocks, REITs and other investments, such as a mortgage investment corporation (MIC).
Even though these bond alternatives may fluctuate in value, some investors take comfort in knowing that an investment is still paying a dividend or distribution and are more willing to hold on to it through market downturns.
Bonds add diversification to your portfolio
Bonds typically don’t move in the same direction as equities. Often when there is a large drop in equities, you see a rise in bond prices.
Fred, are you holding bonds in your portfolio because you’re looking for something that might not move in the same up and down pattern as equities?
If so, one bond alternative that can provide diversification (although not safety) may be gold. You could also consider alternative investments such as private REITs, equity and credit, but these assets are not cashable at any time, not widely available to DIY investors, and must usually be purchased through a properly licensed advisor.
When it comes to bond alternatives, you need to ask yourself why you are holding bonds and what percentage of your portfolio needs to be in bonds. You may find, Fred, that 40% is too much or not enough. Once you know why you’re holding bonds, it’s easier to identify which bond alternative is right for you.
Allan Norman, M.Sc., CFP, CIM, RWM, is both a fee-only Certified Financial Planner with Atlantis Financial Inc. and a fully licensed investment advisor with Aligned Capital Partners Inc. He can be reached at www.atlantisfinancial.ca or firstname.lastname@example.org. This commentary is provided as a general source of information and is intended for Canadian residents only.
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