Higher-yielding bonds are a bit of a “Catch-22” – their fixed income-like characteristics (i.e. higher interest income) would imply that a registered plan would be the preferred account to house them, while their equity-like characteristics (i.e. higher volatility) would indicate a non-registered account would be the ideal garage to park these investment vehicles (in order to take advantage of tax loss selling opportunities). This “hybrid” structure makes them very tax-inefficient vehicles for investors. So should you invest in higher-yielding bonds?
Portfolio 1: 40% DEX HYBrid Bond Index + 60% MSCI Canada Index
In answering this question, I decided to take an entirely Canadian perspective. The DEX HYBrid Bond Index is used as the proxy for Canadian higher-yielding bonds (it is technically a combination of the lowest investment grade bonds as well as some high-yield “junk” bonds). By combining 40% of the DEX HYBrid Bond Index with 60% of the MSCI Canada Index (Portfolio 1), the hypothetical portfolio would have produced an annualized gain of 7.50%, with an annualized standard deviation of 9.43%. The worst 1-year return over the period studied (January 2002 to September 2011) was -23.48%.
Portfolio 2: 40% DEX Mid Term Federal Bond Index + 60% MSCI Canada Index
If we had instead decided to remain extremely conservative with our fixed income allocation, we could have allocated 40% of the portfolio to the DEX Mid Term Federal Bond Index (all AAA bonds) and 60% to the MSCI Canada Index (Portfolio 2). As can be seen in the chart below, the return would have been identical but the standard deviation would have decreased to 8.44%. The lowest 1-year return would have also been more tolerable, at -18.51%.
Portfolio 3: 40% DEX Mid Term Federal Bond Index + 15% MSCI Canada Index + 15% MSCI Canada Value Index + 15% MSCI Canada Small Cap Index + 15% MSCI Canada Small Cap Value Index
For most investors, their fixed income allocation is meant to add stability to their portfolio during periods of volatility in equity markets. If an investor prefers to take on more risk, a more tax-efficient use of their “risk dollars” would be to tilt toward value and small cap stocks (Portfolio 3). By keeping the fixed income portion conservative, and increasing the risk of the Canadian equity allocation, we would have been able to increase the annualized return of the portfolio to 8.54%, while decreasing the annualized standard deviation to 8.71% and lowest 1-year return to -19.66%, relative to Portfolio 1.
Sources: BlackRock Canada, BMO Financial Group, Dimensional Returns 2.0