Knowing your risk and time horizons key to picking fixed income
By Jim Middlemiss • Bankrate.com

When it comes to choosing the right savings product, it's not a case of one-size-fits-all, says Julie Sheen, vice president, term investments, at the Bank of Montreal in Toronto.

It boils down to "when do you need the money" and defining how much risk you are willing to take on, which is often a function of where investors are in their life cycle, she says. Do they need the money to live on? Are they saving it for a specific reason, such as to buy a car, a short-term prospect? Or, is it for retirement 20 years down the road?

Fixed-income products, though considered safer than equities, now come in different styles and sophistication that introduces a range of volatility, Sheen notes, so investors must set out the objective for the savings in order to determine the best product and understand how much risk they are willing to take on.

Know your risk profile
Adrian Mastracci, a fee-only financial adviser at KCM Wealth Management Inc. in Vancouver, adds that "risk is relative to everyone's personal experience" and there are three factors to consider.

The first, he says, is the "ability to take the risks," which relates to the investor's time horizon and available capital. If you're in late retirement and need the money to live on tying it up in a 10-year bond is not the best solution.

Second, is the "willingness to take the risks, which is associated with the investor profile." This is where investors must take a gut check and determine how much loss they can stomach, if any at all.

Last, he says, is the "need to take risks, which is associated with the investment rate of return needed to achieve and maintain personal goals." The answers to these three questions should drive the investment selection, he says. But the problem is most investors fail to consider them or don't accurately assess their tolerance or needs.

With interest rates at historical lows, investors shopping for savings products will find the payback is not that attractive. Fortunately, the prospect of interest rates going down much further is low. However, that means those who lock up their money now could miss out on more lucrative returns as rates start rising.

When it comes to fixed-income products, investors need to remember that the safer the investment and the lower the risk, the lower the return. Moreover, as interest rates go up, the price of existing bonds will decline. So what are your options and which product best suits your needs?

Canada Savings Bonds: These bonds are backed by the federal government, making them one of the most secure investments, since the prospects of the federal government going bankrupt are remote. As such, investors plunking their money down here are likely "extremely conservative" and have a time horizon of more than one year. The best thing is that "your principal won't go up and down," says Sheen.

Mastracci agrees that CSBs "suit somebody who is the guaranteed type." However, he says CSBs are not the great tool they used to be, and for short-term investors, he recommends alternatives such as T-bills.

Canada Premium Bonds: Similar to CSBs, Premium Bonds are best geared to ultra-conservative investors who have a longer time horizon for their investment. That's because the bonds have less flexibility in terms of when they may be cashed in. But, in exchange, they offer a better interest rate.

Real Return Bonds: Another form of CSB, Real Return Bonds appeal most to conservative investors who fear a return of inflation. Mastracci says the downside is there are a limited number of products and to get the maximum benefit of the bonds, they must be held for long periods of time, from a minimum of 10 years to 30 years or more.

Guaranteed investment certificates: The basic GIC is a safe, secure investment designed for conservative investors who want to park money for between one and five years However, Jim Porter, executive vice president of HSBC Securities in Toronto, says the "returns aren't particularly thrilling, especially in the longer-term historical context."

Some banks have created GICs linked to stock indexes that have greater upside. However, these provide exposure to the equity market, so investors must be willing to take on some risk, says Sheen. As well, because the return is linked to stock market performance, Sheen says they're not for short-term investors. You need a five-year or longer horizon. But given the blue-chip nature of the markets they link to and the "high quality stocks, they start to make a bit of sense. The big question is how much do you have to invest and when do you need it. If you have a considerable portfolio then I would probably look at it."

Mastracci disagrees, preferring to keep investments pure. "I would skip the equity-linked GICs. In my view, they're neither fish nor fowl. If an investor wishes to have a foothold in the marketplace, then do so with the appropriate equity vehicle."

T-bills: Of all the savings vehicles, Mastracci favors this one for investors looking to put money away for the short term. "Only use them for short term, up to one year." They're good for saving money to buy big-ticket items or for down payments on property because they can held for weeks or months, as opposed to years.

Corporate bonds: Mastracci says corporate bonds provide a better return than government bonds, but there is more risk to holding them, so investors must be willing to face losses in exchange for a better return. The trick to corporate bonds, he says, is "try not to buy something at premium." Investors want to buy the bond as close to par as possible. Otherwise, if they buy it above par and hold to maturity, they will face a capital loss.

He adds that if you are sitting on a pile of money with the expectation that interest rates will rise, the worst thing you can do is "place the money in short-term instruments, that is under one year, while waiting for the interest rate to increase." That's because you could miss the rising tide. A better idea, he says, is to build a bond ladder.

"My suggestion is go to with a three-, four- or five-year bond ladder. That way the investor has between 20 to 25 per cent of their fixed-income portfolio coming due every year, which can then be invested at the prevailing rates."

Jim Middlemiss is a freelance writer and lawyer based in Toronto. He's a frequent contributor to National Post, Investment Executive and Wall Street and Technology.