Investment Volatility and Loss of Capital – What you need to know
VOLATILITY and LOSS OF CAPITAL are the 2 major concerns for most investors regardless of their age. However most Canadians have a desire (if not outright NEED) to generate returns higher than what are deemed to be ‘safer’ investments such as GIC’s, high interest savings accounts, and government bonds/bond funds.
For those who have an income/cash flow need (those in a RRIF) it is very important to have enough in less volatile assets to cover the next 3-5 years cash flow so that the volatile assets (think equities) do not have to be sold when they are down. It is the selling of assets when they are down that creates a PERMANENT LOSS OF CAPITAL. Volatility in itself DOES NOT CREATE A LOSS! It is what we do doing times of volatility that can create a loss.
It is important to look at where these less volatile assets are invested as we start 2015. What worked well in 2014 may not (think probably not) work as well in 2015 since the interest rate environment will probably be different. In 2014 longer term interest rates (5 to 30 years) actually declined over the year after rising in 2013. This allowed investment grade bonds and investment grade bonds to have total returns HIGHER than the actual interest payments on the bonds. These types of bond funds (Dynamic Total Return, Mackenzie Strategic Bond) had total returns over 6% year to date while the actual yield in the fund is less than 3%. The higher return is a result of FALLING INTEREST RATES during 2014.
Will the same results be achieved in 2015? If interest rates fall about .5 to .75% then the answer is yes. HOWEVER with the U.S. economy improving (dramatically so in the 3rd quarter) then we need to look for rising rates or no more than level rates. If level rates are here for 2015 than a total return in the 2-3% range can be expected for investment grade bonds. If rates rise by .5 to .75% then the same bond funds mentioned above may generate returns similar to 2013 when rates also rose.
During 2013 investment grade bond funds generated returns in the -3% to 0% range. Since I believe the interest rate environment will be closer to 2013 than 2014 than we need to adopt a slighter different allocation starting now. As you can see by the chart below bond funds generated a NEGATIVE return in 2013 and the Dynamic Total Return fund did a better job than most in protecting from the rising rate environment.
For 2015 we need to:
Have greater exposure to SHORT TERM BOND funds that do not have as much interest rate risk (lose value as interest rates rise)
Have greater exposure to TACTICAL or UNCONSTRAINED BOND funds that can make tactical moves to reduce risk from rising rates.
Have exposure to HIGH YIELD bond funds which did poorly in 2014 BUT can do well in a rising interest rate environment since that generally means the economy is doing well. In 2013 (rising rate period) the Aston Hill Strategic Yield (high yield fund) was up 8.25% compared to investment grade funds that had negative returns.
For example a RRIF client might have 1 years cash flow in a short term bond fund, 1 year in a tactical bond fund and 1 year in a high yield bond fund. In addition they would have the distributions from ALL FUNDS going to cash.
If you would like to have your INCOME/CASH FLOW accounts positioned to reduce risk from rising interest rates please let us know or arrange a meeting to discuss.
The views expressed do not necessarily reflect the opinion of Argosy Securities Inc. This does not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. Please consult a professional before making an investment decision.