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The reinvestment risk: higher yielding alternatives to low interest rates.

They may not be overly familiar with the term, but Canadians are increasingly learning about "reinvestment risk". In short, it's the risk you run that a future interest or principal payment will have to be reinvested at a rate far lower than anticipated.

Through the 1980s, many Canadians based their RRSP planning on GICs (and other fixed-income products) earning 10% or more. The process worked as long as the rolling over of short-term maturities could be done at the same or higher levels of interest rates. Otherwise, the high return element of the process crumbles, and investors who built their retirement programs on this portfolio structure are forced to accept pay cuts -- that is, lower income. It's most severe for those who are living on interest income. At 10%, GICs pay $100 per $1,000 invested. At 6%, the return is $60. Four percentage points mean 40% less income.

Do Not Wait for Higher Interest Rates

A long-term investment program should not be built on the expectation that the yield curve will flatten (short-term rates equal to long-term rates) or that interest rates are likely to rise 30%, 40% or 50%. The demand for debt in Canada is falling. Households and corporations are rapidly de-leveraging their balance sheets, paying down debt, and financing expenses out of current income and cash flow.

Even the Canadian government's appetite for debt is changing, as reflected in the lack of significant fiscal stimulus package in the '91 and '92 federal budget. Further evidence can be found in the introduction of the Goods & Services Tax which the federal government staunchly supported in the face of initial protests. Increasingly, the Canadian taxpayer is demanding fiscal responsibility from all governing bodies; from city councils and school boards to provincial and federal levels of government.

And what happens when the demand for anything falls -- whether it be vegetables, computers, cars, or houses? The price drops. In the case of debt, the interest rate falls.

We believe the decade of the 1990's will see gradually lower interest rates and a persistent upward-sloping yield curve. Dreaming about days past will not solve the problem of lower income -- and it will not solve the problem of rolling over GICs, T-Bills and Term Deposits at lower interest rates.

No Risk, No Return

The old adage, "No Risk, No Return" is at work here. The required portfolio adjustment process will be one of taking more risk to offset the previously unforeseen reinvestment rate risks that have eroded income. The big shift is a risk shift.

Staying Conservative; Extend Maturities, Bond Products and Ladder Maturities

First, investors hoping to replace lost income should realize that risks will be higher now. A partial solution, is to extend maturities out the yield curve and to accept more maturity/time and therefore, risk. Instead of two to three year fixed income products, investors may have to look at maturities of seven to ten years or more.

Similarly, fixed income derivatives such as Midland Walwyn Retirement Savings Bonds, offer a conservative government guaranteed product that have extended maturities but with an attractive yield after compounding.

Fortunately, there are reasonable investment choices that, when combined with the mechanics of laddering maturities, will help investors move toward solving the income dilemma. Laddering maturities is one approach in which various amounts of portfolio principal are invested at various maturity levels, for example, three, five, seven, ten or fifteen years.

But What About Inflation? The Role of Equities

Using an approach of laddered, fixed-income maturity which involves marginally more risky fixed-income investments will go a long way toward improving the income deficiencies of "fixed-income only" portfolios.

But what about inflation? How are we going to protect the portfolio from the erosive, even corrosive, effects of inflation? Remember, inflation reduces the purchasing power of assets by 3-6% per year (it's currently uncommonly low at 1-2%). In just ten years, the purchasing power of assets would be 30% less in a world of 3% inflation.

If we would find an asset with an income stream that would grow 3-6% over time, we could at least keep pace with inflation with that portion of the portfolio. Unlike fixed-income investments, the wonderful thing about equity investments is that their income flows (earnings and dividends) grow.

This is why equities outperform bonds in the long run -- pure and simple. Equities are a preferred hedge against inflation.

Of course, the "No Risk, No Return" adage is at work here too. The volatility of principal invested in equities is greater than in fixed-income alternatives. The average of the long-run return is upward, but from time to time equity prices can stagnate or fall. If an investor requires the invested principal when values are depressed, he or she must sell at a loss. The risk in a diversified equity portfolio is not in the long run but rather in the short run, and it involves a question of timing.

Reinvestment Risk will be something for all investors to contend with in the foreseeable future. Recognizing its existence is easy -- determining an appropriate investment strategy will take more effort. A clear understanding of your investment goals coupled with the knowledge that reaching those goals will not be as easy to attain are your first steps in seeking out higher yielding alternatives.
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Title Annotation:Strive
Publication:Manitoba Business
Date:Nov 1, 1992
Words:880
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