Falling rates push stock prices into dangerous territory

By Gordon Pape in The Income Investor

It may be hard to believe but our already rock-bottom interest rates are drifting even lower. Recently, the yield on the benchmark 10-year Government of Canada bonds fell to 0.98%. That means investors are willing to accept a return of less than a percent a year on their money in exchange for the safety of an AAA rated security.

Across the border, the yields on 10-year U.S. Treasuries fell to an all-time low.

If you think rates can?t go any lower, look at what is happening overseas. Some $10 trillion worth of sovereign bonds issued by countries like Japan, Germany, France, Switzerland, Netherlands, and Belgium are in negative territory. You pay them to hold your money!

This is an unprecedented situation and it does not bode well for the global economy. The bond markets are suggesting that growth is going to be very slow for a decade or more. In fact, if these signals are correct, based on past history we may be heading into a recession.

However, we have to put things into context. The latest round of interest rate declines appears to have been fuelled in part by the Brexit vote in Britain. That fed into the overall anxiety about the state of the economy and provoked a flight of capital to the safety of highly rated bonds. But the eventual impact of Brexit is complexly unpredictable at this stage, and the process will take years to unfold. In the meantime, the U.S. economy is doing well, with 287,000 new jobs created in June. Those aren’t numbers you would expect to see if a recession were on the horizon.

The bottom line is that we are living through some difficult times for income investors. Here are my suggestions of how to proceed through this financial jungle.

Reduce your risk. With interest rates so low, the temptation is to reach for yield in the stock market. Returns of 4% or more look extremely tempting when your bank is offering 1.6% or less on five-year GICs.

But be cautious. Investors’ pursuit of yields has driven up the prices of many stocks to what may be unsustainable levels. For example, BCE shares yielded more than 5% for several years. But the stock has been rising steadily since January, when it was trading at around $52. It was trading on July 15 at $62.43, pulling the yield down to 4.4%. (If there is no increase in the dividend, yields drop as the share price rises). The trailing 12-month price/earnings ratio was 19.7 at that point. By those measures, BCE looks expensive .

Many other income stocks are in a similar position. BMO Financial Group, which I recommended in September of last year at $71.33 with a yield of 4.6%, was recently trading at $84.98, with the yield down to about 4%.

Interest-sensitive stocks are normally at the lower-risk end of the spectrum but right now demand is pushing their prices into what could be dangerous territory in the event of a market correction or a reversal in interest rate trends. So be very cautious about opening new positions at this time or adding to existing ones.

Maintain bond positions. Yields may be low but any bond positions you hold are probably turning in a nice profit so far this year. That’s because yields and prices have an inverse relationship. A higher bond price translates into a falling yield, so the more rates drop the greater the value of your bond in the market.

Some people have a lot of trouble understanding that so look at it this way. Assume you buy a $1,000 bond that yields 2%. You receive $20 a year in interest for as long as you own it. Rates decline and a new issue of the same quality yields 1.5%, or $15 a year. Your old bond yields 33% more, so it will go up in price.

That explains why bonds and bond funds are doing so well this year. The return for the iShares Canadian Universe Bond Index ETF for the first half of 2016 was 4.86%, which is much better than anyone would have expected back in January. Some mutual funds have done a lot better, including the Phillips, Hager and North Total Return Bond Fund, on our recommended list, which is ahead 5.4% year to date (series D). The company’s High-Yield Bond Fund (also on our list) has done even better with a year-to-date gain of 7.43%.

Search for deals. With rates so low, you want to get the best deal you can on your cash holdings. They’re out there; you just have to search for them.

Last week I went with a friend to see what the banks are offering on savings accounts. We went into a TD branch and were provided with a list of rates. I wasn?t surprised to find that the best rate they would give us on a savings account was 0.55%. Given the overall rate environment, it was about what I expected.

I was surprised when we went across the street to Scotiabank, however. They are currently offering 2% on your savings until the end of August. After that, the rate drops to 1.5% on money that is held in the account for 90 days. That’s almost three times more than TD is offering.

On-line banks offer even more. The new EQ Bank, which I have mentioned in the past, is still paying 2.25% on their Savings Plus Account. Details at www.eqbank.ca.

Summing up, you should avoid adding more risk during this period. That does not mean to avoid equities, but don’t overweight them in your portfolio. Hold on to your bonds and get the best return you can find for your cash holdings.

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