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Prudent Investor Update, April 4, 2018

Risk and Return: Insights on stable investment options that preserve capital


The Right Mix: Weighing different fixed income options

Municipalities tend to take a conservative approach to investing, emphasizing fixed income securities, which deliver generally stable returns on a predictable schedule. While not free of risk, fixed income securities are generally viewed as less risky than other types of investments, notably equities. Portfolios can have a combination of cash, fixed income and equities. Finding the right balance depends on your risk tolerance, and your objectives in terms of income, diversification and capital preservation.

Ideally you want to create a robust portfolio that doesn’t all move together in the same direction as the market. A mix of different securities will provide a greater measure of stability. MFS Investment Management Canada manages ONE Investment’s Bond, Money Market and Universe Corporate Bond portfolios. Their experts provided an overview of how some common fixed income investment options might fit into an overall municipal portfolio.

GIC and Term Deposit: These fixed term deposits with a financial institution offer guaranteed returns, but because of their simplicity and relative safety, rates of return can be low relative to other investments. They can offer stability during volatile markets and protect capital. Given they are with a single financial institution, they do not contribute to diversification.

Banker’s Acceptance: Highly liquid and short-term, these are credit investments created by a non-financial firm and guaranteed by a bank. They typically offer higher rates of return than a GIC, given the additional credit risk. They offer a high degree of capital protection. Because of their short-term nature, they do not provide a high level of diversification unless you have a portfolio of BAs from different institutions.

Bonds: Bonds offer a reasonably stable source of income compared to other options and are typically less volatile than equities. A portfolio of various government and corporate bonds can help balance risk and generate better returns overall. This bond portfolio approach can also contribute to greater diversification within the overall investment strategy. Bonds can be less volatile than equities and therefore provide some portfolio stability when equity prices fall sharply. Bond prices are inversely related to interest rate hikes as well. Rising interest rates can be challenging for bond returns over the short-term - as rates rise, bond returns may be modest or even negative. However, a rising rate environment improves the long-term return potential for the asset class given the higher expected rate of return due to a higher yield.

Principal Protected Notes: PPNs are not a fixed income product because the rate of return can vary and as a result, the level of income can vary as well. The rate of return depends on what the PPN is linked to, for example an equity index or commodity index and therefore it will generally reflect the performance of other segments of the overall portfolio, such as equities. These are complex structured investments that guarantee the principal at maturity. Fees may be complex and there may be penalties if redeeming early, which could mean some loss of capital.

Focus on Capital Preservation

When investing with taxpayer dollars, losing one dollar can be more painful than foregoing a dollar that might a have been gained. With capital preservation often a high priority in municipal investment policies, it’s important to understand how different products can protect capital, and at what cost.

ONE Investment Advisory Committee member James Giles provided insight on capital preservation. He noted that all the options need to be weighed in terms of the overall level of risk, the potential returns, and the timeframe over which the funds will be invested. It is important to know whether you might need to access funds quickly, so the liquidity of the investment is important.

High Interest Savings Accounts are a good tool for preserving capital, as you can only lose money if there is a failure of the financial institution. Therefore, investing with a well-capitalized Canadian bank is important. The rates on HISAs are generally reflective of the current interest environment. ONE Investments’ HISA, for example, has just negotiated a new rate of 1.915% with complete liquidity and no transaction fees.
Money Market Funds are generally short-term (one to 18 month) investments that also offer a good level of security with slightly higher returns that bank interest rates. This can be a good option for short-term municipal capital reserves.

Bonds and bond portfolios are another low-risk option. The more secure bonds are “investment grade” meaning they are issued by governments or large, well-capitalized corporations with credit ratings of BBB or higher.  Bonds offer a fixed rate of return over a fixed time frame, such as 5 or 10 years. Funds often can be accessed sooner, however, as there is a secondary market if you need to sell a bond before its maturity date. As stated before, bond prices are inversely related to interest rates hikes. Higher interest rates can lower existing bond prices as investors are able to get higher returns elsewhere.
Another way to invest in bonds is through a portfolio of different quality bonds with different maturities, managed by a fund manager. Bond funds can offer slightly better returns for just slightly greater risk. Every bond fund will have a “duration” – a formula that measures its price sensitivity to interest rate changes. For example, a duration of “3” means that if the interest rate went up by 1%, the rate of the bond would decrease by 3% if sold early.

GICs and Term Deposits are some of the simplest investment options to offer fixed terms and rates of return. Again, investing through the larger Canadian financial institutions offers a greater level of security. Funds are locked in for the term of the investment – although these can be short. The tradeoff for this level of safety is that they generally come with low rates of return. The main risk of these products is that although capital is preserved, with inflation, it may have less purchasing power at maturity.   

Principal Protected Notes are more complex structured investments. While they will protect the principal over a fixed period of time, the rate of return is not guaranteed. The fee structure can be somewhat complicated. The key question with PPNs is determining if what you are paying is worth it for the protected principal. You need a thorough understanding of PPN, including how returns are calculated and how fees are calculated, to determine if it is an appropriate investment.  

Most people see equities as higher risk because the principal cannot be guaranteed. However, equity investments in mature institutions with good cash flow and low debt can be a good choice, especially if you have time on your side to ride out market fluctuations and valuations are reasonable.

The goal is to understand your needs.  If some monies are absolutely required then safe, liquid investments are more appropriate.  If monies are available for longer time periods and not specifically earmarked, then higher return/risk choices may have a role.  It’s important to remember that the better the returns, the less pressure on the tax base and municipal budgets.

ONE Investments has been providing a broad range of options tailored to municipal needs for 25 years. ONE is now exploring new services to support municipalities as they navigate these investment options and strive to build a portfolio that protects tax dollars, while delivering good returns that can help communities to grow and thrive.