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Bond Risk

Richard Croft
December 16, 2013
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We are witnessing a major shift in risk allocation across asset classes. As the bond market prices in tapering, medium and longer term rates are rising. With short term rates at or near zero, and likely to remain there for some time, the yield curve is steepening.

As these price adjustments work their way through the system, we have a scenario where bonds are riskier than equities. Rather than bonds trading at about 70% of the volatility of a broad equity index, there is real risk that fixed income volatility will exceed that of equities for perhaps the first time in history!

Conservative income seeking investors are re-thinking their investment strategy. Shortening the duration of their bond allocation is one approach, although that has a serious impact on income. Another strategy is to move into sub-investment grade bonds where higher yields tend to dampen volatility related to interest rate shifts. But assuming higher default risk is not something most conservative investors are comfortable with.

Covered calls on Canadian equities may provide a third low risk choice, particularly if you focus on blue chip Canadian companies that pay decent dividends. BCE Inc. (TSX: BCE, $45.24) is one that comes to mind. The annual dividend is $2.33 which equates to a 5.15% yield, and the company has been regularly raising the dividend since the Teachers Pension Plan decided to opt out of their purchase offer.

Now take the dividend and add some premium income from the sale of covered calls, say by writing the May 46 calls at $1.00. I am using at-the-money calls because this trade is being examined as an alternative to fixed income securities. The idea is to make the equity look like a bond with a higher yield and a fixed upside at expiry.

The covered call strategy has a long history of reducing volatility usually by as much as 30%. Much like we see with the Mx Covered Call Writers Index (symbol: MCWX), which writes covered calls against the iShares S&P TSX 60 Index fund (symbol: XIU). When you measure volatility in the MCWX, it is about 70% as volatile as a long only position in XIU. That brings the covered call strategy in line with longer term volatility associated with fixed income securities.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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