Find yield for your clients

Market uncertainty has pushed retail investors to look for yield rather than returns, which has made fixed income investing expensive and potentially risky.

Yet despite the contracted range of genuine yield-generating opportunities, individual investors with prudent risk exposure thresholds still have reasonable prospects for growth.

Here, three top investment advisors weigh in on how to navigate today’s challenging economic terrain.

The view from above

“When looking at shorter-term goals,” HighView Financial Group chairman Gary Brent explains, “we adopt a reasonably conservative approach.” For a three-year time frame, he suggests looking to the short-term bond market, adding in money market instruments as the term progresses.

“By way of example, three years out we would have 100% short-term bonds, two years out we would have 50% short-term bonds and 50% money market, while one year out would be addressed with 100% money market. Short-term bonds would have maturities out to three years and consist of Government of Canada, provincial and corporate bonds, with provincial and corporate bonds used to raise yield.”

In the current low-interest-rate environment, Brent suggests that to boost yield, portfolios should include more corporate bonds, which he goes on to say ought to be of the “highest quality, including banks and utilities.”

Looking towards the medium and long terms, Brent says, “To address the yield component of the portfolio, we will add in longer-term bonds, again employing Government of Canada, provincial and corporate bonds, and then start adding income-oriented real estate,” which should “take your yield up into the 7% to 8% range.” Brent also suggests dividend-oriented domestic stocks and, “to further enhance yields, we would also look to add global dividend-oriented equities.”

The most important thing to keep in mind, Brent emphasizes, is to avoid chasing returns with a quick-hit transaction strategy—a doomed-to-fail approach that “so many people have gotten into trouble with.” A sound investment strategy will be designed around “clients’ goals over time and within risk constraints they will be comfortable with.”

This is accomplished, Brent explains, by “spending the time to both assess and understand their individual risk characteristics as well as the goals they would like to fund and the associated time frames. It’s about structuring portfolios to match clients’ goals over time and minimizing risk exposure in doing so. It’s not about chasing returns.”

Walking the curve

Robert Gorman, chief portfolio strategist at TD Waterhouse, observes that although market conditions have improved, high cash levels among many investors suggest “there’s no less uncertainty. People who are in money market, earning, let’s say, 0.5%, realize that won’t cut it over the long term. So what do they do?”

Gorman suggests a number of options geared towards different levels of risk tolerance. Those wanting to avoid equity market risk completely should look to high-grade corporate issues, he says. They offer a higher income stream than money market instruments, “and at the same time, corporate bonds are generally a little shorter in duration than government bonds, so the weighted average term is a little shorter than other fixed income investments, making them a little less susceptible to any adverse impact of rising bond yields—should that take place.”

Even in the current low-interest-rate environment, corporate yields should be in the 4% range for high-grade portfolios. This is “nothing to write home about,” Gorman adds, but it’s certainly a major improvement over the 0.5% you’ll get from money market instruments.

Arriving at the “next stop on what we’ll call the risk curve,” Gorman suggests advisors working with clients who are aiming for an even higher income stream should look to preferred shares, which typically offer dividend yields in the 5% range.

“And because of the dividend tax credits, which effectively make every dollar of Canadian dividends like getting $1.30 in interest after tax, that’s like getting perhaps 6.5% interest. In this environment, that’s pretty attractive.”

Gorman emphasizes, however, “not all preferreds are created equal. They have a lot of different characteristics, a lot of different traits that most people aren’t familiar with, and I typically tell people buying preferreds that it really does pay to work through an advisor who can distinguish one from another.” Gorman adds that one of the things investors need to be mindful of when looking at preferreds is they “tend to be fairly illiquid…and as a result the bid-ask spreads can be fairly wide. So they’re typically not a trading instrument. You would be buying them for the longer term.”

Gorman suggests one last stop on the risk curve—what he calls dividend growth stocks, which offer “one of the really significant opportunities for Canadian investors going forward.”

A considerable number of Canadian companies, he explains, currently have common share dividend yields in the area of 3.25% to 3.5%. With the dividend tax credit, this will translate into roughly 4.5% in interest. Gorman identifies banks and other financial companies, as well as communications companies, as falling into this category.

But this, he says, is only a beginning. “There are several other points here. Number one, and this is very, very important, most of these companies…will increase their dividends by 4% to 8% a year.” For investors, this means two things. First, “it provides them with a hedge against inflation—that stream of income goes up—in sharp contrast to bond coupons that don’t change.”

Secondly, “as those dividends go up, they tend to form a rising floor out of the share prices, so you get a decent stream of income to begin with that is tax-advantaged. It will tend to grow over time, and the share prices typically will show some moderate capital appreciation as well.”

In many cases, Gorman adds, these dividend stocks will show “less volatility than the stock market overall,” exposing investors to a lower level of risk. In Gorman’s assessment, then, medium- and long-term investors “who can handle some market volatility” should look to dividend growth stocks for enhanced levels of income—and a level of risk “that will let them sleep at night.”

The tortoise and the hare

Juliette John, senior vice president for investment management, and lead manager for the dividend income fund and Canadian dividend fund at Bissett, advocates tilting towards common and preferred shares of companies that use sustained dividends as a way to “reward shareholders for their continued interest and ownership of the shares.”

These companies, John says, “will tend to be the ones that actually perform better over the long run, because you can’t pay a sustainable dividend if the earnings stream is not healthy or growing, in that it would end up compromising the overall operation of the company.” This approach is especially attractive in the current low-interest-rate environment, John adds.

For John the evidence shows not only that dividend-paying entities will perform better over time but that they do so “with a lower level of portfolio volatility.” In other words, “for clients who may be risk-averse or wanting to get income, investment in yield-oriented securities has actually done better for them.” Dividend-paying companies “may not be the most exciting companies out there,” but excitement won’t necessarily get you to the finish line first.

“It’s almost like the tortoise and the hare, where companies that don’t pay dividends can be considered a bit of a hare and companies that do pay dividends are a little bit tortoise-like, where they are less aggressive, have lower levels of volatility, tend to be more methodical and go about their operations quarter in, quarter out, without the high swings and peaks and troughs that a company that is maybe more cyclical in nature would have.”

John suggests a wide range of companies across multiple sectors will appeal to the dividend-oriented investor. On the energy and utilities side of the index, Emera has recently raised its dividend, and John expects TransCanada Corporation to raise its as well. She also points to the telecommunications sector, which performed well in 2010.

“It went through a period of higher levels of capital expenditure, and those capital expenditures have come down to a slightly more manageable level. And with the lower levels of capital expenditure, companies are able to generate higher levels of free cash flow, which allows them to look more at whether they’re in a position to raise dividends compared to earlier in the decade.”

Advisors should also keep an eye, John suggests, on a number of other areas on the index, including income trusts. “They are in the process of converting into corporations right now—they are a good group to look at, because some investors may not have been permitted to own trusts under that legal structure. Going forward, wemay see a broader appeal of the corporate structure to investors.”

A word of caution, however, is in order, says John. “Dividend-paying entities have become quite attractive to investors because of the low-interest-rate environment,” she says, “and so there is some caution required as a result of the share price performance that we’ve seen so far in 2010. They do tend to move in an inverse relationship to interest rates.”

Rates will eventually rise, and when they do, it will “open up the universe of income-oriented investments to investors, and so they may be able to look elsewhere, outside of dividend-paying equities to satisfy their income needs.”