David's Weekly - August 25, 2023

Plan - don't predict

In this week's letter:

• Income Bulls: A refreshing opportunity in bonds - but maybe not forever
• Fixed Income Bears: Keep in mind where we are in the cycle
• A few things to consider in your own investment planning

Income Bulls: A refreshing opportunity in bonds - but maybe not forever

Abstracting out the idea of bulls and bears, let's talk about some ideas related to making money in your bond portfolio while also reducing your risk.

The Big Picture: Retirees have reason to celebrate high rates

For the purpose of being conservative in financial plans, we have used a return of 4% as a base rate for many years. Of course, markets have handily outperformed this measure. But, for financial planning, the move to more conservative, income-generating securities such as bonds has had an overall negative impact on returns in portfolios compared to the equity component. This is true to the extent that we've seen many retirement portfolios pushed hard out the risk curve so that retirees were depending almost entirely on dividend-paying equities and growth stocks to pay their bills. This isn't necessary in today's environment.

Using an equal-weighted blend of US Treasuries, Investment Grade Corporate, and High Yield Bonds, we can see that in this current state of the cycle, one can generate sufficient income from bonds to pay for many retirement plans.

Hitting your retirement planning targets (for now) with Bonds

When it comes to bond opportunities, we've been saying, "get 'em while they're hot," for some time now. We can't know when and how the opportunity set will change, but it's important to keep in mind that we're likely closer to the end of the rate hike cycle than to the beginning. This reminds me of a classic anecdote we often share when it comes to stock tips.

You still own that?

Back on the trading desk from '97 to 2015, our "constructive argumentation" often touched on high-conviction single stock ideas. Working with partners for a long time can generate some very strong trust leading to shared trades amongst the team. It was always funny when one of us would jump into a "me too" trade only to let it languish while everyone else moved on. This would lead to complaints like - "Wow, that stock is really a dog", with others responding, "You still own that?" The point is that trades often peak and fall, as we'll discuss just below.

Fixed Income Bears: Keep in mind where we are in the cycle

Just as we talk about below in Food For Thought, it's important to keep your eyes open as markets and cycles change. Nothing works the same forever. One thing that separates the best investors from the pack is the ability to keep thinking ahead, reviewing your thesis, and adjusting to market conditions.

Currently, the yield on bonds relative to equities has diverged significantly, favouring bonds on an absolute basis and, more important, on a risk-adjusted basis. That is, you get an attractive yield for owning bonds while also having less downside risk than stock market equivalents. As we can see below, bond yields for a basket of corporate investment grade bonds nicely beat the S&P500 yields for the last 12 months. The last time we saw this was during the 2008 credit crisis when the bonds of high-quality companies like banks and autos were trading for 30 cents on the dollar. Talk about discount bonds!

Investment Grade Bond Basket yield beats the pants off the S&P500 trailing yield

But, keeping the long-term in mind - things are actually kind of normal now

While we can celebrate the upgrade to portfolios because of our current rate environment, it's worth remembering that a strategy of buying GICs and discount corporate bonds which can generate some equity-like capital gains, might taper off. In fact, it will taper off when central banks start to pivot.

The chart below shows us how much extra one gets paid to take the risk of owning stocks vs. owning bonds. As is clear, we had about 20 years, from 1980 to about 2000, where one was better off owning bonds and where the extra payout from owning equities was negative. When Greenspan came in and kicked off the pattern of holding rates too low for too long, that equation reversed.

Although bonds are very attractive now, the chart below shows that we are just at neutral, or the long-term average. However, we don't know if the next 20 years will look more like 1980-2000 or 2000-2020. If it's the former, retirees will be even happier, and home prices and the stock market might be a bit softer with growth stocks benefiting less from lower rates. If it's the latter and rates go lower again, then we can expect plans to be forced further out the risk curve all over again.

Equity Risk Premium vs Investment Grade Corporate Bonds

A few things to consider in your own investment planning

Given how much sense it makes to reduce equity risk in the context of current fixed-income opportunities, now would be a good time to look at your plans and review the following:

1) Strategic Asset Allocation:

See if the time is right to adjust your asset allocation, the split between stocks and bonds in your portfolio, further towards fixed income. Earn as much but risk less!

2) Bond Strategies: a) Riding the Yield Curve, Extending Duration; b) Buying at a Discount

a) Based on the assumption that rates WILL go lower eventually and that there will be an impact on longer-dated bonds, now could be a good opportunity to start increasing exposure to bonds maturing out beyond 3-5 years. Why? When rates go down, bonds rally, and longer-dated bonds rally the most.

Remember, what you earn from purchase to maturity on a bond is fixed by the price you pay at the start. However, if rates move, the timing of your returns can change. Lower rates will pull more returns to the present. Higher rates will push down your bonds, and you'll have to wait longer to collect your full payment.

b) This trade still has life. If you buy a bond that is trading at less than its face value of $100, your returns will include both the coupon payment as well as the capital gain from the increase in value to par reached at maturity. Assuming the bond is investment grade, your default risk is relatively lower. But your capital gain could be competitive with what you might receive in the stock market, albeit at a lower overall risk.

Food For Thought: The role of luck in life (and investing)

A very important part of the wealth management business is providing investment guidance to successful professionals and entrepreneurs. We often get into discussions about individual stock ideas that are often driven by recent fads and front-page news. The challenge is always to effectively transfer our knowledge of markets from decades of experience to add value both by helping clients make the right choices as well as to avoid mistakes. Long story short, we always advise clients to set aside a portion of their investment portfolio, say 10%, for their own ideas while allowing us to work full-time on protecting the other 90% of their assets for retirement.

So where does luck come into the picture?

Portfolios of those same clients often have one or two outsized winners which are dragged down by a plethora of positions in a loss or that are marked to zero, revealing the skeletons of past mistakes. The existence of the big winners is what drives people to try again at the markets and gives them the confidence that their wins are skill-related, and not just based on the randomness which pervades the markets. Our view is that a few winners can actually be dangerous because they provide an incentive to go back to the gambling parlor and do it again.

Quit While You're Ahead

There is an outstanding book written by Nasim Nicholas Taleb called "Fooled by Randomness", that we've mentioned many times because it had a substantial impact on our views on trading, the markets, and life. As a trader, you look for what's called an "edge" in the market and that means that you have some advantage that allows you to generate profits. That edge can disappear though, and only the most capable traders will recognize that the game has shifted. A perfect example of traders being "fooled by randomness" and continuing to return to the parlor every day was demonstrated in a strategy called "buying on dips". This cyclical strategy was perfectly suited to the dot com bubble when traders only had to buy on down days to make money as the market just continued to go up, until ... Those same traders ended up giving it all back when the market no longer bounced. Rags to riches to rags.

This ties into a recent article on why people garden which talked about why people do things that they can hire professionals to do. The reason? For the pleasure. Don't give up your interest in the market, but don't give up your day job either!

So, when thinking about your next trading ideas, it's useful to remember that you're competing in a market where it's very unlikely that you know something that others don't. And, if everyone else knows, what's the edge in the trade?

If your portfolio has its fair share of negatives and you're looking for an approach to smooth out your returns in the future, please get in touch: [email protected].

And with that, we'll wrap as always with RBC Dominion Securities' Portfolio Advisor Group's Global Insight Weekly. Enjoy.

By Portfolio Advisory Group

In this week's issue :?

• Persistent resilience:?Broadly encouraging economic data have supported risk-bearing assets this year, though the recent backup in bond yields appears to have dented investor sentiment. We continue to believe an “up-in-quality” approach to portfolio allocations remains sensible.
• U.S. bond prices swing on mixed economic signals:?Bond price volatility has risen as investors await Fed Chair Jerome Powell’s address to the central bank’s monetary policy symposium. Will he offer insight into potential policy decisions or stick to platitudes on flexibility amid a commitment to price stability? We look at market moves ahead of his comments

This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. The inventories of RBC Dominion Securities Inc. may from time to time include securities mentioned herein. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities that are affiliated. *Member-Canadian Investor Protection Fund. RBC Dominion Securities Inc. is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. ? / TM Trademark(s) of Royal Bank of Canada. Used under license. ? 2023 RBC Dominion Securities Inc. All rights reserved.