Time to float

Debbie’s an investor. B&D all the way. Doing great. “Look at Toronto!” she exuded to me yesterday as the TSX high-fived across 21,000 for the first time.

In case you hadn’t noticed, the maple market’s gained 23% in 2021. If it were a house in Victoria or Etobicoke, you’d be pumped. But this is better. Equities, and ETFs based on them, are liquid. No realtors. No commissions. No land transfer tax, property tax, condo fees or utilities. No insurance or maintenance. No neighbours or tenants. No bugs. No snow. And when using a TFSA, RSP or RRIF, no tax, either.

Why is this happening?

Companies are making money as the pandemic recedes and the economy expands. We’re back at pre-virus job levels. The banks are raking it in. Oil is way past eighty bucks and likely going higher as demand outstrips supply. Vax rates have soared to 80% and beyond. Consumers are spending hugely, borrowing their butts of and cities are repopulating. Government stimulus is flowing and the central bank has kept the spigots wide open.

But wait. There’s change in the air. Not so much for the economy- prospects are good – but for CBs and the cost of money. And, maybe, for portfolios. The latest inflation number is arresting – 4.4%. That’s beyond forecasts and the fastest rate of growth in almost 20 years. It’s above the Bank of Canada’s target range for the sixth month in a row, bringing big pressure to up rates sooner than later.

No wonder. The cost of everything is swelling. Gas, wow. Food. Clothes. Insurance premiums. Real estate. Meanwhile the busted supply chain means a year’s wait for new appliances and dog-knows-how-long to get the Lambo you ordered.

Deb’s on top of that. She can see rates have only one way to go in response. And she sent me this (very good) question:

There is a high probability that the portion of the portfolio invested in bond funds, albeit short term, will go down. I understand why they are in the portfolio. (offset to equities, shock absorbers, reduces volatility etc…). However with little room/low probability for rate reductions from hereon in and therefore only a small chance for any modest appreciation in value or return perhaps the bond funds might as well be in cash or an equivalent to serve the shock absorber purpose? Can some or all of the bond funds not be in a money mkt fund and at least earn 0.25% instead of a high probability of loss? I can’t wrap my head around this.

Answer: First, nobody owns bonds for yield. They’re insurance. Shock absorbers. They generally rise when stocks fall, and saved a lot of people’s bacon in March of 2020 when Covid crashed into our lives and drove stocks down by a third. You just never know what’s coming…

Second, yes, rates are going up. Sooner than most people believe, including everybody in the vaxport-protected comments section. Traders are now making bets on the CB hiking in a few months, with three increases (or more) in Canada in 2022. This will add at least three-quarters of a point to mortgages, which is a big deal. And more coming after that. Mr. Market just doesn’t believe the soothing words from the Bank of Canada that inflation’s temporary.

So, yeah, it’s coming. And as rates/yields increase, bond prices fall. This is why the 40% fixed-income component of a balanced portfolio needs to be rate-protected (as we have been doing for our clients consistently). So in addition to the safe shock-absorber federal & provincial debt ETFs, Deb’s portfolio contains a floating rate bond fund (which benefits from rising rates) as well as a healthy weighting of preferred shares – the rate reset kind. In total, almost half the ‘safe’ part of the portfolio is invested in stuff that increases in value when the cost of money does the same.

There’s more: the portfolio also includes corporate bonds, which outperform government debt in a rising rate environment. In fact, the ETF providing this also has a yield north of 3.5%. That beats the pants off a money market fund return. Meanwhile preferred shares have done exactly as this blog suggested they would when the pandemic started to come under control. They erupted. Values are up close to 20%. Prefs also pump out a 4% dividend. And you get the dividend tax credit. Everything but a massage and a cigar.

In short, don’t mess with the 40%. Never load up the FI portion of your portfolio with just one government bond ETF. Understand the impact higher rates will have, and invest accordingly. But don’t dump balance in favour of pure growth, or assume there won’t be more storms ahead.

When it comes to investing, human nature is not your friend. We fear loss. We get greedy. We vacillate, chase returns and let emotion lead. We read dodgy blogs, watch questionable people on YouTube, then make trades. Bad idea. Stop.

The best portfolio strategy is to correctly set it, forget it, and take the dog for a walk. She knows what matters.

About the picture: Remember Shane? He’s the house-lusty mechanic everyone had an opinion on two days ago. This is his pooch. “I just wanted to say thank you for your help,” he writes, “my wife and I had a great conversation last night about our finances and are starting a plan thanks to you. I’ll come back to you for advice when the children pop out. Here’s a picture of our first born child, Tucker.”