Why it’s time to stop ignoring fixed income

Saving was much simpler for our grandparents. They worked, socked their money away in something safe like Canada Savings Bonds, and let it compound over time. Returns were small but you were always a little bit wealthier on Tuesday than you were on Monday.

The personal finance term for that sort of saving is fixed-income. It means putting your money in an investment that generates income consistently and reliably while protecting your initial investment. The objective of fixed-income in a broader investment portfolio is to help offset risk from stocks, which are exposed to drastic equity market swings but have the potential to boost the entire portfolio.

The fixed-income to equity ratio depends on the individual investor's tolerance for risk. A large fixed-income portion permits bigger gambles and potentially bigger gains at the riskier end of the spectrum. If things don't work out on the stock side, the fixed-income portion of your portfolio will act as a cushion to keep your nest-egg safe. The priority of fixed-income is safety before gains.

As you get older, and closer to retirement, the fixed-income portion should grow to reflect your diminishing tolerance for risk.

Not all fixed-income products are the same

Somewhere along the line fixed-income broke for many investors.

Rock bottom interest rates have reduced the incentive to save and opened the floodgates for products that juice returns, raise risk and pump up fees for the investment industry.

Bonds have been replaced by bond funds — baskets of fixed-income products with risk ranging from triple-A safe to high-yield junk. Investors, willingly or not, pay fund managers to trade them at lightning speed on the global bond market. Instead of waiting for the income at maturity, bonds are traded for a higher price by interest rate speculators. When they are wrong, the value drops, and the investor loses money.

Wrong or right a percentage of the total amount invested goes to the mutual fund company and a portion of that often goes to the investment advisor who originally sold it — each year. From an industry perspective bond funds generate bigger and more consistent fees than bonds.

It's enough to make you want to stuff your savings in a mattress, but the risks of doing that can be even greater.

Right now inflation in Canada is looming at two per cent but economists agree the cost of living is on the rise and wages have failed to keep pace. That means those dollars sitting in a chequing or savings account will become fractions of themselves as time goes on.

Even granny's beloved Canada Savings Bonds are paying out as little as 0.65 per cent this year. You won't even keep up with the current two per cent inflation rate unless you're prepared to lend Ottawa your money for at least 10 years — exposing your savings to the risk that inflation could top 12 per cent as it did in the early 1980s.

Over the past year even money market funds — baskets of short term debt — have not kept pace with inflation. Once the average fee of one per cent is deducted the average Canadian money market fund has only returned 0.37 per cent.

Where investors can turn

But smart saving is not dead. One way to keep your savings at pace with inflation is through a good high interest savings account which can pay about two per cent. If the rate doesn't rise with inflation you can take it — and your interest — out at any time.

If you're in it for the long haul, a good strategy can boost returns without sacrificing safety, and give you the flexibility to take advantage of higher yields when they finally come along. With the help of a trusted financial advisor it is possible to create a true fixed-income portfolio your grandparents would be proud of — your own basket of bonds.

It's called a laddering strategy because the bonds in the basket are laddered according to maturity. The number of rungs may vary according to the individual investor but in a low interest rate environment like this it's good to hold short-term maturities so your money isn't stuck earning low yields when rates finally rise.

The best yields for the least risk right now are probably Guaranteed Investment Certificates. GICs are sold by banks and trust companies and deposits are insured by the Canada Deposit Insurance Corporation for terms of five years or less.

One year GICs can pay over two per cent annually. The longer the term, the higher the yield — a three year GIC pays over 2.5 per cent and a five year GIC can pay over three per cent. For a comprehensive look at rates in Canada, check out RateSupermarket.ca

By laddering equal amounts of GICs on, for example, five rungs (one to five year maturities) an investor will have money coming to maturity every year, permitting several opportunities to find the best going rate at the time.

It's a safe way to squeeze the most out of your money and keep ahead of inflation while you do what your grandparents did - relax.