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An equity fund for bond investors

Finding it hard to make money in a pure bond fund these days? Try a conservative income fund.


Date: May 12,2015

It’s hard out there for bond investors today. Interest rates are still at near historic lows – the Government of Canada’s 10-year bond rate has fallen nearly 11 per cent this year – which makes it difficult for Canadians to both make money in fixed income and beat inflation.

Most conservative investors have had to grin and bear it, though many have jumped into high- yielding equities for income, which has likely thrown their traditional asset mix off balance.

Others, however, have found another way to stay conservative and generate more than the 1.55 per cent yield of 10-year bonds. They’re purchasing “conservative income funds.”

These funds have a relatively modest allocation to income-oriented equity securities – usually not more than 30 per cent. They can provide income, hedge inflation and be less susceptible to downside risk than balanced portfolios with higher equity allocations.

This portfolio is appropriate for investors who are looking to gain some exposure to a rising equity market, but within a very conservative framework, says Joanna Bewick, a Boston-based portfolio manager at Fidelity Investments.

“Over the past 15 years, investors in the equity market have withstood two vicious downturns and they are – understandably – a little bit nervous,” says Ms. Bewick, who manages the Fidelity Conservative Income Private Pool. “For a lot of these investors who want income and equity in smaller increments and in a less volatile package, this more conservative fund might be appropriate.”

For many, these mutual funds can be used to fulfill their conservative allocations within a portfolio. But, because of the equity component, they also provide a hedge against a potential interest rate increase, which tends to have a negative impact on bond prices.

These funds are also flexible and can be tweaked depending on market conditions. For instance, Ms. Bewick is able to increase her equity allocation to 30 per cent, but she can also take even more risk off the table and reduce her stock exposure to 5 per cent.

Risk-return rewards

Due to their high fixed-income content, these funds often draw a comparison to bond funds, but, because of the equity component, they have a distinct edge over pure bond funds, says Steve Tate, a Vancouver-based certified financial planner and co-author of Paycheques & Playcheques.

“When interest rates rise, the equity portion of the fund will more than make up for the potential losses on the fixed-income side,” he explains. “As long as the investor is invested into the appropriate asset allocation, these funds will have a greater chance of making more money and achieving higher returns over the long term than a straight fixed-income fund.”

Of course, equities are more volatile than bonds, which means that conservative income option could see more ups and downs than a pure bond fund. However, Ms. Bewick says that over the long term the reward may be worth the risk.

“When you take on a slightly higher risk profile, it can have the potential for slightly higher return,” she says. “Investors with a slightly longer time frame and a slightly higher risk profile can have some volatility in their portfolio, especially with the trade-off of having equity return potential.”

Not just for retirees

Naturally, this asset allocation works well with retirees who don’t want to put their nest egg at risk, says Ms. Bewick, but it isn’t suitable only for an aging demographic. It can also be good for those who still have bad memories from the recession.

“It can take years, sometimes a generation, before your typical retail investor regains confidence in the market,” she explains. “There’s a general risk aversion bias in most investors, so the conservative allocation is interesting for them.”

This fund can also be useful for people who want to park their money in the short-term – typically at least a year – but it may not be suitable for someone who needs cash in a few weeks or months.

In that case, says Mr. Tate, a client would be better off sticking with cash-like investments, as there is still some risk on the equity portion of the fund. These funds work best when they’re used to secure opportunistic growth within an overall defensive strategy.

To achieve that higher growth, Ms. Bewick is able to access bonds on all parts of the yield curve, but right now she owns high-yield bonds, floating-rate loans and some emerging market debt. Overall, she has a 60 per cent allocation to Canadian stocks and bonds and 40 per cent to the rest of the world.

While these funds aren’t for everyone – a more aggressive investor may want an equity fund with 70 per cent stocks – they can be useful for people who need a reliable stream of income, but want a bit of capital gains too.

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