Portfolio Diversifiers

I assume that all investors understand the value of diversification. It is all about developing a long-term portfolio strategy that will deliver performance within a tolerable level of risk.

Bonds are typically used as a portfolio diversifier. The fixed rate of interest delivers critical cash flow to the portfolio to offset the principal risk associated with equities. However, that fixed payout can cause fluctuations in the bonds’ price particularly in a rising rate cycle. When rates rise, the value of the bond declines and the longer the term to maturity the greater the impact that has on the price of the bond. In the current rising rate environment, bonds may be the highest risk asset in the portfolio.

The challenge is to weigh the benefits of the inherent cash flow against the risks associated with an asset class that will be negatively impacted by rising rates. One approach is to look at securities that provide above average cash flow but are less interest rate sensitive than bonds. Consider for example, preferred shares and covered calls.

Good quality preferred shares make sense if you believe they are undervalued relative to bonds. Prior to the financial crisis, good quality preferred shares (rated P1 or P2) typically traded with a yield that was 80% of the rate payable on the same company’s ten year corporate bonds.

The yield differential reflected the tax advantages of earning dividend income versus interest income. A qualifier that still exists. The preferential tax treatment created a structure where the after-tax yield in a non-registered account from a preferred share was slightly higher than the after-tax yield on the company’s corporate bonds. And prior to the financial crisis most market participants believed that good quality preferred shares were not that much riskier than the bonds on the same company.

The financial crisis changed all that. Many good quality US preferred shares stopped paying dividends because management could do so without fear of plunging their company into bankruptcy. While the interest payments on bonds are mandated through the bond’s indenture no such protection exists for preferred shareholders.

Unfortunately, many Canadian preferred shares got painted with the same brush though most continued to pay dividends throughout the financial crisis. The result, Canadian preferred shares are currently yielding about 120% of the yield payable on the company’s ten year corporate bonds. That change in valuation makes these instruments an excellent alternative to bonds.

A Covered Call Substitute

The other fixed income substitute would be covered calls. That may seem counter-intuitive since we are typically writing covered calls on equity positions which is hardly a diversifier. However, that view may be too harsh.

A good diversifier should have a low, or ideally… negative, correlation with equities. As equities fall the diversifier tends to move in the opposite direction effectively dampening volatility within the portfolio. Bonds have always been a good buffer because institutional investors typically shift from stocks to bonds during equity market declines. You can also make the case that bonds provide stability in that they tend to exhibit about 70% of the volatility of a well-balanced equity portfolio.

However, in the current environment, stocks are close to all-time highs and interest rates are expected to rise. A sell-off in equities may be accompanied by rising rates which may result in bonds falling as well. The only diversification from bonds may be the fact they move at a much slower pace than equities.

In the current rising rate environment, you can probably get the same diversification from covered calls with a better rate of return. To that point, covered calls exhibit about 70% of the volatility of a long equity position (see the MX Covered Call Index versus a long only position in iShares S&P/TSX Index ETF). The strategy also generates dividend and capital gains income providing yet another advantage over interest income.

If you choose to write calls on interest sensitive stocks, you may gain yet another diversification advantage. For example, writing covered calls on BCE Inc. is an interesting bond substitute. As a yield play, BCE tends to move similarly to bonds as rising rates tend to depress the shares. However, the sale of a covered call can offset some of that decline.

Keeping with the interest rate theme, you could also write covered calls on Canadian banks. But with banks, you have an asset that will benefit from higher interest rates because it improves the net interest margin.

The bottom line is that no long-term investor should hold only one asset class… particularly equities. The volatility associated with equities is simply too high for most investors to tolerate. The result, individual investors making bad decisions at exactly the wrong time.

Using bond substitutes provides diversification which tamps down portfolio volatility allowing investors to stay the course through a typical market cycle. The added benefit; enhanced tax advantaged cash flow that will buoy the long-term performance of the portfolio.