Stress test your holdings to guard against inflation

rcarrick@globeandmail.com

Even healthy portfolios need a stress test every now and then.

This was the case a year ago, when lots of investors were grooving on record-high stock markets and were neglectful of bonds. Now, with some interest rates on the rise, it's once again time to probe for weak spots in your portfolio.

The rise in rates so far might only be apparent to people keeping track of what's happening with mortgages. Bond yields have a major influence on borrowing costs for fixed-rate mortgages and, lately, yields have moved noticeably higher.

So far, the impact of this rising-rate trend on investors has been minimal. But what if inflation becomes a concern as a naturally rebounding economy benefits from the steroid-like stimulus that has recently been applied by governments around the world? "We talk to every client about this," said Anthony Layton, president and portfolio manager of PWL Capital in Montreal. "It's on the horizon. We're close to deflation at the moment, but we know that we have to be ready. The next sort of volatile event could be an inflation event."

Many experts scoff at the idea of inflation posing a threat any time soon. David Kelly, the chief market strategist for JPMorgan Funds in New York, said in a discussion paper issued this week that excess slack in the economy will keep inflation under control for several years.

But while Mr. Kelly said inflation isn't something that should dominate investing decisions, he believes it's worthwhile for long-term investors to insure against it.

Start your inflation stress test by looking at the bonds you own either directly or through mutual funds and exchange-traded funds.

"If you're an investor who is worried that bond yields are going to shoot higher because governments have provided so much stimulus, then you probably don't want to own a bond, period," said Dave Schaffner, CEO and head of fixed income at the Vancouver money manager Leith Wheeler.

But let's be realistic. You want bonds in your portfolio to act as a hedge against another downturn in the stock markets, but you need to be smart about which ones you hold.

Mr. Schaffner said government bonds are most vulnerable if rates spring higher because of inflation. In practical terms, this means the price of your government bonds or ETFs and mutual funds holding government bonds would fall on your monthly account statements.

You would continue to get interest and have your principal redeemed at maturity, barring a worse cataclysm than we've yet seen. But many investment advisers have told me over the years that clients often complain about watching their seemingly safe bonds fall in value from month to month. (Note: Guaranteed investment certificates don't have this problem because they're supposed to be held to maturity and not traded.)

In his client portfolios, Mr. Schaffner has squeezed federal government bonds down to just 15 per cent of his fixed-income holdings, with 25 per cent accounted for by higher-yielding provincial bonds. The rest is allotted to corporate bonds, which need a stress test of their own.

The story of corporate bonds is that they're in rally mode after being thrashed almost as brutally as stocks last fall and early this year. Mr. Schaffner argues that corporate bonds are still a little undervalued by traditional measures, and this could help keep them buoyant.

"There's probably still some more capital gains potential, even if rates rise further," he said.

High-yield bonds - higher returns and much higher-than-usual risk of default - are most resistant to rising rates and inflation. Mr. Schaffner said that if rates are rising because of strong economic growth, it's a positive for high-yield bonds because it suggests a better operating environment for financially shaky companies.

Real-return bonds will hold up best in an inflationary environment because that's exactly what they're designed for. The semi-annual interest payments from these bonds rise if the cost of living increases, and so does the amount that investors get when the bond matures.

"If you're assuming interest rates are going to go up and inflation is going to be bad, then the only bonds that survive that type of attack are the real-return bonds," PWL Capital's Mr. Layton said. "We have a constant ratio where about 10 per cent of our bonds are real-return, and we have been increasing them for the last little while."

Preferred shares are up next in our stress test. They're shares that are bond-like in that you own them primarily to generate a regular flow of income (dividend income, as opposed to less tax-efficient interest income for bonds). Normally, preferred share issues with returns that don't float along with interest rates would certainly be vulnerable to price declines in a rising-rate world.

But preferred shares suffered the same fate as corporate bonds in the financial market crisis. This means preferred shares - including perpetuals, which have no fixed redemption date - might actually rise a little more in price even if rates rise.

"We've seen the quick money from December to now," cautioned Tara Quinn, an associate with the portfolio advisory group at ScotiaMcLeod. "But Scotia Economics isn't forecasting rising inflation until two years from now. So you're going to see capital appreciation going forward in the short term."

Stocks, particularly those in the commodity sector, are attractive in an environment where the economy is surging and rates are rising. "If rising interest rates have to do with trying to combat inflation, then the assets that best do that are growth assets, and that's inside the equity component of a portfolio," Mr. Layton said. "I'd certainly want to hold on to all my equities."

Not all stocks do well when rates are rising, though. Examples can be found in the interest-rate-sensitive areas like banks, utilities, pipelines and telecommunications. "I would be careful about holding a preponderance of banks and things like that because their cost of money goes up as rates go up and therefore their margins go down," Mr. Layton said.

But strategist George Vasic of UBS Securities said rate-sensitive stocks now benefit from the same dynamic as corporate bonds and preferred shares. They've been beaten down in price and a reasonable increase in bond yields shouldn't interfere with them.

Mr. Vasic argues that rising bond yields reflect growing optimism about the financial markets - investors no longer need the security of government bonds, so they're selling them and moving on. He's more concerned about central banks raising what are called administered rates to quell inflation.

"There's plenty of buffer for bond yields to rise without affecting dividend stocks," Mr. Vasic said. "But if inflation eventually soared, say two or three years from now, then that would undermine dividend stocks."

STRESS TEST