By Tom Bradley

The team has been working hard to keep client expectations in check. Markets have been good and the Steadyhand funds have performed well, so it’s natural that clients start to expect more from their portfolio.

We’re being a particular downer in the area of income investing. In my view, it will be difficult to generate the kind of returns in the next 5 years that the Income Fund did over the last five (7.4% per year). Interest rates are much lower today and the risk premiums (the potential for extra return) on investment grade and high-yield corporate bonds have shrunk.

In our client presentations earlier this month, we talked about the dangers of ‘reaching for yield’ without considering other factors such as valuation (what the business is worth) and diversification. Right now, it feels like there’s a lot of reaching going on and little consideration being given to the other factors.

I wouldn’t call it a bubble … yet … but there are warning lights flashing on my dash board. For instance, the return gap between income-oriented stocks and other types of stocks has been unsustainably wide over the last 5 years. There isn’t a day goes by that I don’t receive an email announcing a new fund or product that has income, dividend, guarantee or yield in the name. It’s boom times in the new issue market for corporate and high-yield bonds. And I’m even starting to see young investors (who have no need for income) with portfolios that look like those of their parents or grandparents.

While not a bubble, I do think the insatiable thirst for yield will produce some nasty surprises over the next few years, particularly in products that have ‘promised’ unsustainably high monthly payments. The surprises will likely take the form of distribution cuts and/or unexpected declines in the capital value.

What’s more important than a few surprises, however, is the fact that portfolios are steadily getting narrower in their scope and more specialized in their pursuit of income (like the one we discussed in a recent post). Income securities should be part of a well rounded portfolio, but not the whole thing. I firmly believe that over the next 5+ years, the better performing and less risky portfolios will be the ones that also hold small and medium sized companies, non-dividend paying companies in sectors like technology, resources, consumer products and healthcare, and companies based in the U.S., Europe and Asia.

My thinking on this issue is heavily influenced by the following:

1. The yield of the overall bond market (as measured by the DEX Universe Bond Index) is now 2.4%, as opposed to 4.5% five years ago. The regular income from bonds is perceptively lower, and the potential for capital gains is limited (bond prices go up when yields go down).

2. While bonds are most directly impacted when interest rates change, other income-oriented securities like high dividend stocks and real estate are also highly sensitive to rates.

3. On the stock side, two of the big income sectors, banks and REITs, have benefited mightily from strong tailwinds over the last decade. At best, those winds are dying down, but it’s possible they’ll shift 180 degrees and become headwinds.

4. The Canadian banking industry is one of the best oligopolies in the world and will continue to be extremely profitable. But banks have been the chief beneficiary of rising house prices, increased home ownership and the rapid expansion of consumer debt. If Canadians do as Bank Governor Carney and Finance Minister Flaherty want them to - lower their debt and start living within their means - then the competition for mortgages and consumer loans will escalate. And if the equity in their homes goes down due to price declines, the banking system will grind to a halt pretty quickly.

5. Like the banks, REITs are sensitive to interest rates, just way more. The valuation tool used by home buyers is a mortgage calculator (how much can I afford?). For institutional real estate buyers, the measurement used is the capitalization rate or cap rate, which is keyed off of interest rates. The lower bond yields are, the lower cap rates are and as a result, the higher prices are. But when rates go up, property values will drop and the industry will become a lot less fluid. When that happens, it will be a test for investors – will the income flow be enough to keep them in when asset prices are dropping?

As we’ve said (yes, we are repetitive when we feel strongly about something), income securities belong in a diversified portfolio as long as their business fundamentals and valuations make sense. But to generate a reasonable, above-inflation return over the next 5-10 years, we think it makes sense to hold a broader array of assets. Not only do we think returns will be higher, but given where interest rates are today, the risk of capital loss will be lower.

The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns.