High Yield Bonds: A Piece of the Retirement Income Puzzle?
Today's Trivia Question:
Which performed better in the last 5 years, Nortel shares, or Nortel Bonds?

Are you looking for yield, and dependable income? Do you want to avoid risk, yet can't get enough of a return from GICs or bank deposits? Well, you're in good company - many investors confront exactly the same problem these days. If the decade of the nineties was all about capital gains and big profits, the next decade might well see a focus on yield, and reliable income. Baby boomers are now entering their retirement years, and their appetite for risk has dramatically altered after the stock meltdown of a few years ago. After all, it's one thing to lose a substantial portion of your retirement savings when you're 25, and have years to wait out the recovery: its quite another matter altogether when you're 65 and on the verge of retirement. But at the same time, retirement funds must still provide income, and bank deposits, GICs, and even Government Bonds can't provide the necessary cash flow, given today's low interest rates.

Faced with this dilemma, investors have embraced financial products and securities that feature large and reliable cash distributions, usually on a monthly or quarterly basis. These investments include preferred shares, common shares with high dividend yields, income trusts and other income funds, split shares, and mutual funds which specialize in providing a stable income to holders. These assets have all performed well. This issue of Focus on Investments takes a look at another income-producing asset - high yield bonds - and discusses why you should consider owning them.

What exactly are high yield bonds? They are corporate bonds, issued by companies that do not have an investment grade bond rating. For one reason or another, these companies do not meet all the strict criteria required by bond-rating agencies to merit their top ratings. Now, you may well be thinking at this point that this sounds awfully risky, and that surely these companies must be junior mining companies or other highly speculative companies, but that's clearly not even remotely the case:

75% of the TSX Composite (Canada's premier stock index, representing a cross section of all Canadian companies) is made up of companies that would be classified as high yield Issuers.

Investors seem to have their investment approach to these companies completely backwards. Although it is rather common to own the shares of these companies, not many investors have considered owning their bonds. Which, as the table on the next page so clearly illustrates, is a shame: the bonds have outperformed the shares by a huge margin, with much less risk:

**As of 28/10/2004. Bond returns are an approximation only based on returns of outstanding bonds (5 years) or on coupons of most recent maturity (10 years)

*Index return used as a proxy. All returns are annualized.

Source: Dynamic Mutual Funds

As a group, the bonds outperformed the stocks by 3.4% annually over 5 years, and a whopping 7.2% annually over 10 years. That's a huge difference, which can literally turn a failed investment strategy into a success. Clearly, quite often the bonds provide higher returns than the equities, with much less risk! In fact, high yield bonds should be considered more as very low risk equities, rather than as high-risk bonds.

Why have these bonds done so well? One of the main reasons is that they pay much higher interest than the alternatives: whereas government bonds may pay interest of 3-4%, high yield bonds may have coupons of 7 - 8% or more. Historically, that extra interest has served investors well.

Another interesting aspect of high yield bonds is that they are less risky than government bonds when it comes to the effect of interest rate increases. This is because interest rates generally rise as a result of an improving, growing economy. Therefore, as the economy improves, the companies that issue high yield bonds see their credit ratings rise as well, helping to offset the effect of higher interest rates. Since government bonds bear no credit risk at all, there is no scope for improvement in that area, and they accordingly bear the full brunt of interest rate increases in their prices.

Currently, Canadians are not particularly well invested in the high yield bond market. It's a rather new and undeveloped market for us. Whereas US pension funds are quite comfortable with and accustomed to owning high yield bonds in their portfolios, Canadian pension funds own almost none. This is likely to change dramatically over the next decade. Investors will be, dare I say it, forced into this asset class, in their scramble to achieve the income their retirement plans require. The remarkable returns achieved recently in the income trust market indicate just how thirsty investors are for income. High yield bonds actually have some advantages over income trusts, which are really 100% equities, in a tax-advantaged structure. High yield bonds will occupy a superior position to that of income trusts in the case of a company getting into financial difficulty. Income trusts can cut their payouts whenever business conditions deteriorate, whereas bonds represent a contractual obligation on the part of the company. In many cases, shares in a company can lose almost all their value, even while the bonds remain relatively unscathed (witness Nortel's case!)

Just as in the case of equities, with high yield bonds it is important to do careful research. It is a very different exercise from looking at stocks, where earnings, growth, industry prospects and valuation are the main criteria. In the case of high yield bonds, the focus is on cash flow and financial ratios. This requires expertise far beyond that of the average investor. It's also important to hold a large, diversified portfolio of high yield bonds, to reduce the risk. This is difficult for the average investor to achieve. Therefore, I highly recommend that investors purchase high yield bonds via a fund of some kind.

I'd be more than happy to further discuss the merits of high yield bonds for your specific financial situation. I have over 16 years experience in financial services, both in Canada, Singapore and London. Call me today for a free, no-obligation consultation. It will be well worth your time.

Sincerely,

Scott Swallow, HBA, MBA, CIM