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Income Generating Portfolios: Bonds vs. Dividend Paying Equities

Income Generating Portfolios: Bonds vs. Dividend Paying Equities

If you are happy with GICs paying 2.5% on a five year term, then this article is not for you.  With interest rates at all time lows and approaching zero are bonds truly an appropriate place to place assets at this point in time?  In these uncertain times, where markets are up one week and down the next, it is extremely challenging to capture any value out of the market.  Lately, every time the market looks like it is going to fall off a cliff, due to some form of credit event, central bankers have been stepping in to prop up the market with added stimulus.  Stimulus, in this case, is only money printing.  Money printing places inflationary pressures on the economy and interest rates typically rise. 

Due to uncertainty and market gyrations you sometimes need to structure your portfolio to pay you while you wait.  Depending on the risk profile of my clients, I deploy the income generated in their portfolio in 3 ways for them.  First, use income generated to supplement the client’s income; second, deploy some of the income generated for special situations to invest in riskier assets that have potential for growth; and third, deploy income generated to re-invest in the same income generating issue or similar issue to compound returns for the client. 

The main types of income producing assets are:  Bonds (including High Yield and Junk Bonds), Convertible Debentures and Preferred Shares, and finally Dividend Paying issues.  For the purposes of this article I am going to focus on Bonds and Dividend Paying Issues. 

When investing in bonds investors face two principal risks:

1)      Credit risk – when the borrower cannot repay you
2)      Interest rate risk – when interest rates rise

Let’s look at interest rate risk further.  The past few years rates have been falling and are now at all time lows.  If you have held bonds through this period of time you have done very well.  To pictorially show how the mechanics of rate changes affect bond prices I have incorporated two charts on the following page.  As a proxy I have used the 10 year US Treasury note.   The first chart shows the price of the US 10 Year Treasury Note and the second chart shows the yield of the US 10 Year Treasury Note.  The price chart has been rising and the yield chart has been falling.  Price and Yield have an inverse relationship to one another, as price rises, yields fall and vice versa.

From a technical perspective if you look at the price chart I have drawn two blue lines above the RSI and the price action.  The blue lines are showing a divergence.  In other words while price has been displaying higher highs, RSI has been displaying lower highs.  A divergence of this nature usually signals a change in direction.  This is a weekly chart, so this could take some time but the implications are lower bond prices and higher yields.

With yields at an all time lows and approaching zero and a divergence in the price chart, we will most likely be facing higher rates down the road.  An environment where rates are rising is not an environment to want to own bonds, especially bonds with longer maturity.   As rates rise the value of the underlying bond will fall.  Having said the above the Fed in the US has committed to a low interest rate environment to 2014.

The Central Bank, here in Canada, is telegraphing rate hikes.  What do you do as an investor if you want income from your portfolio?  I’ve been directing clients towards dividend paying issues.  Although there is some interest rate risk associated with dividend issues, there is an opportunity for appreciation in the underlying asset.  In other words, there are two chances to grow your assets:  income from the dividend and capital appreciation.  If market weakness surfaces, you will be paid to wait for more favorable conditions.  In addition dividends are taxed more favourably thaninterest income.  A typical dividend paying portfolio would look like the following:

Industry

Country

04-17-2012
Yield

Withholding tax on
Distribution

Yield After
Withholding Tax

Wireless Technology Company

Thailand

5.02%

10%

4.51%

Sugar

Canada

6.32%

0%

 

Marketer & Distributer of fuels

Canada

7.47%

0%

 

Coal Storage + Shipping

Canada

4.46%

0%

 

Petroleum Pipeline

Canada

5.40%

0%

 

REIT

Singapore

5.39%

0%

 

Utility Company

Australia

9.16%

30%

6.41%

Water Utility

Thailand

5.73%

10%

5.15%

Oil & Gas Exploration, development and Production

Canada

6.52%

0%

 

Here are the criteria I use when selecting your investments:

Country Selection Criteria

  • Expected 1-2 year trade surplus
  • Real interest rates exceeding those of USA
  • Low debt-GDP ratio
  • Favourable GDP growth estimates

Industry Selection Criteria

  • Favourable growth rate
  • Good fit with expectations for secular shifts in supply/demand
  • Resource availability
  • Favourable political environment

Security Selection Criteria

  • Favourable dividend yield
  • Attractive valuation
  • Strong balance sheet
  • Superior management

 

Please give me a call to discuss how we can work towards incorporating Dividend Issues into your portfolio!    
1-888-216-9779 x 402 – edgar.burton@europac.ca

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