Income Investing: 5 Ways to Raccoon Proof Your Income Portfolio

Linda (@lindaodnokon) and I went camping last weekend, something we’ve never done before together. $1000 later for equipment and a rental SUV to pack it all in, off we went for two days at Rondeau Provincial Park. Although we had never set up the new sleep tent and kitchen shelter, a couple of false starts later we managed to get everything set up within an hour.

There’s something about being a life-long experienced camper that allows you to slip into an easy routine and literally let the cares of everyday life slip away. A few bottles of barley pop later we set about making dinner. Of course, the steak in the cooler was frozen; luckily there was a fish and chip stand just outside of the park gate.

Picking up firewood at the same time as dinner, back at the site we had a great greasy meal and as darkness descended, lit a fire. Sitting around drinking vodka sodas and watching the flames, I thought about putting the dry goods and coolers into the truck. But in the fullness of the night as the flames died down we went to bed.

The next morning, I woke at dawn and went into the kitchen tent to make drip coffee with a new gadget that fit over the stove. Looking down, I realized that we had been visited by raccoons. Little evidence remained of the dry good feast the family had enjoyed. Croissants, eaten. Hot dog buns, mostly eaten but I’m guessing didn’t have the same appeal as the giant loaf of pumpernickel bread, which like the croissants, eaten. Oatmeal raisin cookies? The raccoons left them behind. The double fudge chocolate cookies, eaten. And for a little salt after the sweets, they ripped open a bag of dill pickle chips although I think they would have preferred the plain ripples instead.

By the time I had cleaned up the mess and policed the campsite, stooping and scooping racoon poop, I got to sit down and enjoy that first cup of coffee which was extraordinarily good.

You can only smile at yourself when you make a mistake the way I did. Shame on me for knowing better and not doing anything about it. The second night the family returned hoping to find a feast and instead rifled through the pots and pans; everything was safely put away in the back of the vehicle.

What do racoons have to do with your income portfolio?

After an incredibly long period of ultra-low interest rates (coming up on nine years) central banks the world over has started signaling the end to accommodative monetary policy. At home BOC has raised rates with the promise of more to come.

Many investors I know are relieved that the impact on the market hasn’t been larger. If you read the many commentaries on the subject in the press, non-financial and financial both, I’m not surprised if you’re not seeing the Armageddon scenario hinted at. As a peer of mine oft repeated, “it all depends on the time frame”.

We’ve now seen a fundamental shift in expectations, a tsunami of change, that takes time to manifest itself. We can speak of the Ontario government’s role and the OFSI actions to cool down the housing market in the GTHA, but in my opinion the biggest factor has been a shift in interest rates in the face of an increasingly overextended buying public. While the availability of credit becoming more constrained and more expensive, the first signs of cooling and reversing are evident.

I’m not about to argue the nuances of the whys and wherefores of any issue. I don’t possess the expertise nor the time to develop it. Instead of figuring out how the racoons got into the kitchen tent and went about dining, it was enough that I knew it was going to happen and what I needed to do wasn’t done.

The danger of income investing without paying attention to rising rates is not much different than my racoon experience. You know that something is going to happen but through your own complacency, inertia or competing demands you ignore the steps you need to take.

I suggest to you we are entering a period of rising interest rates. I further suggest that the behaviors that drove many investors to taking on increasing levels of risk in search of yield are going to lead to some erosion of capital.  If you know that the racoons are going to come, it’s time to racoon proof yourself.

5 things you can do to position yourself for higher rates

1.      Bond Yields

The yield curve for all forms of bonds are going to change. As the yields on government guaranteed investments rise, sovereigns, yields on corporate bonds of all types will also go up but so too will the risk spread.

There is a tradeoff between safety in shorter term time horizons but there is a way to play the curve to your advantage. There is, for example, a steep drop in yield at the inflection point which is generally around 7 years. By cherry picking issues sitting on the high side, as rates go up over time, the decline in duration mitigates or eliminates the risk.

Similarly, trading higher duration high beta bonds (BBB) for lower duration higher grade bonds allows you to preserve much of the yield. Rate reset bonds are particularly attractive in this case – think NVCC Canadian Bank bonds.

Be opportunistic – I can’t tell you with confidence what the shocks in the system will be, but if you look back to the first quarter of 2016 you’ll see the spike in the spread between corporate and government bonds provided an incredibly profitable short-term opportunity. Buying then left you with great quality issuers with much higher yields than you could find in the following quarters.

2.      Preferred Shares

Rate reset preferred shares have been a great way to add yield to your portfolio. If you were like many people who bought them coming out of the great recession, you probably got burned because the interest rate expectations five years out never materialized.

I’ve been buying a portfolio of rate reset preferred shares in the form of a ladder. Knowing which ones to buy is an art and you must be patient because preferred shares by their very nature are illiquid. The yield you will receive is comparable to current yields on recent new issues.

I’ve also been selling recent rate reset preferred share issues knowing full well that the longer duration to reset makes them more vulnerable to price declines.

I’ve also been pulling apart both mutual fund and ETFs invested in preferred shares. Some are better positioned to take advantage of shifts in interest rate expectations than others.

3.      Fixed Income ETFs

Many fixed income ETFs are indexed-based.

I am always surprised to find people already investing in these ETFs because of the high distributions without realizing most of the bonds in the index trade at a premium. That means there is grind – a phenomena where the ETF must pay out more that the yield of the underlying portfolio building in a capital loss. Think of it this way: the ETF pays and declares income at say 3% that you’re taxed on even though you only earned 1.5%.

More importantly, while bonds have been in many cases the superior investment to be in for the last 35 years, the long-term reversal in this bullish trend will ultimately work against you. Fixed income investments based on an index are problematic in that the bond index was never meant to be invested in, but rather a reading on the overall health and condition of that market. Many people are going to experience a decline that is permanent.

4.      Blue Chip Stocks

A great deal of the run up on high dividend paying stocks has been a matter of increasing dividends in a desert of decent yield.

Canadian banks trade at a lower PE than US banks for any number of reasons, but some of it is the much higher dividend payout ratio. While I don’t expect to see the dividends cut, I similarly don’t see there being much likelihood of the recent history of dividend increases. After all banks aren’t immune to consumers in distress.

There’s any number of things you can do such as aggressively writing calls as premiums rise or selling the stock, buying a leap and investing the rest for yield in say the same company’s bonds of the same duration.

5.      REITs

Of all the yield investments that you can hold, REITs have the greatest Yin and Yang in any environment.

When you own a REIT, generally you hold a fractional interest in all its properties. They are fundamentally a flow-through entity and you are subject to all the factors that affect their operation.

Think of it as having not one major risk, but a multitude of balance sheet (refinancing risk, cap rate on asset purchases) and income statement (top line, operating cost) factors that you need to assess.

On the top of that a REIT isn’t just one entity: it describes the business structure that it operates in and describes everything from office, retail, industrial, retirement homes, hotels, apartments, etc. Each of these sub categories are industries of their own.

Generally, I have been avoiding REITs that are sensitive to reductions in consumer spending and have been examining Industrial REITs that are primarily logistics based.

One last thing: there is a natural spread between the yield on REITs and large blue-chip stocks. If for any reason the yields on the blue’s go up from a stock value decline, it will also pressure the yields on the REITs up. It is an inverse relationship just like bonds; yields go up, prices fall.

Conclusion

There is always a risk in making a major call on changing fundamentals. After all there isn’t a person I know that didn’t think that the world of low interest rates was going to last almost a decade. On the other hand, there is sufficient change already showing up to start to move your assets in the right direction.

I’m going camping again with Linda in a little less than two weeks. This time the food goes into the vehicle.

Industrial Alliance Securities Inc. (IAS) is a member of the Canadian Investor Protection Fund (CIPF) and the Investment Industry Regulatory Organization of Canada (IIROC). iA Securities is a trademark and business name under which Industrial Alliance Securities Inc. operates.

This information has been prepared by David Chellew, Portfolio Manager for Industrial Alliance Securities Inc. (IAS) and does not necessarily reflect the opinion of IAS. The opinions expressed are based on an analysis and interpretation dating from the type of publication and are subject to change. Furthermore, they do not constitute an offer or solicitation to buy or sell any the securities mentioned. For more information about IAS, please consult the official website at www.iasecurities.ca. David Chellew can open accounts only in the provinces where he is registered.