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Expectations for inflation and interest rate hikes are on the rise, reinforcing the need for investment approaches that actively seek to balance income opportunities against key risks - interest rate risk, credit risk, currency risk and inflation risk – that can readily damage returns and erode capital in changing market conditions.

We believe one or a host of our active income solutions can serve a crucial role in a well-diversified investment portfolio. Learn more about a selection of these offerings, and get to know the risks they actively seek to overcome in pursuit of enhanced risk-adjusted returns.

Income SolutionsRisks CoveredFund Performance*
Series FInterest rate riskInflation riskCredit riskCurrency riskYTD1 year3 year5 yearSince inception
IA Clarington Core Plus Bond Fund2.13.5--2.9
IA Clarington Floating Rate Income Fund1.65.44.1-4.2
IA Clarington Growth & Income Fund0.611.4--7.8
IA Clarington Strategic Corporate Bond Fund3.113.84.96.46.6
IA Clarington Strategic Income Fund4.713.65.58.98.9
IA Clarington Yield Opportunities Fund2.24.5--5.7
* Performance as at May 31, 2017

Learn more about four key risks and how iA Clarington's active approach can help, see below.

Credit Risk

The risk of default on a debt instrument

In this low-yield environment, investors are looking to asset classes that provide the potential for higher levels of income. But when looking for higher yields in income markets, as the old saying goes, “There is no such thing as a free lunch.” One risk an investor assumes when buying a higher-yielding instrument is credit risk. This is the risk of default on a debt security through a failure by the issuer to make required payments or to maintain covenants.

Fixed-income instruments can be categorized into two broad categories: investment grade and high yield. The categories are based on an assessment by credit rating agencies of the debt issuer’s ability to meet its financial commitments (Chart 1). Companies that are seen as more vulnerable to problems in meeting financial commitments will have to pay a higher coupon rate for investors to buy their debt.

 

Chart 1: Credit risk: Rating overview

Credit risk: Rating overview

Source: Standard & Poor’s.

 

These higher coupons translate into higher yields. The current range of higher yields can be seen through a review of differently rated asset classes, examining their credit spread over government bonds (Chart 2).

 

Chart 2: Credit spreads of select rated asset classes

Credit spreads of select rated asset classes

Source: Federal Reserve Bank of St. Louis (April 30, 2017). Data represents the Option-Adjusted Spread (OAS) of various subset (by credit rating) of the BofA Merrill Lynch U.S. Corporate Master Index. The subsets include all securities with a given investment grade rating. The BofA Merrill Lynch OASs are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization.

 

Lower-rated instruments can offer a substantial yield premium compared with higher-rated issues. But the trade-off is that default rates typically increase as credit quality decreases. A study going back over 30 years reveals that, on average, cumulative default rates increase from low single-digit percentages for issuers of investment-grade-rated bonds to over 45% within five years for issuers rated CCC or below (Chart 3). Investors seeking a higher-yielding payoff in lower-rated securities need to be extremely mindful of the capital loss potential associated with credit risk.

 

Chart 3: Global corporate average cumulative default rates by rating (1981-2015)

Global corporate average cumulative default rates by rating (1981-2015)

Source: Standard & Poor’s Global Fixed Income Research and Standard and Poor’s CreditPro®, for the period of 1981-2015.

 

Help reduce the risk

There is no shortage of ways to participate in the higher-yielding asset classes. But navigating the opportunities and pitfalls requires skill and diligence that are actively applied. A sound approach includes assessing the economic fundamentals that can affect a company’s ability to meet its financial obligations and avoid default. In turn, the ability to structure a sufficiently diversified portfolio of holdings is a measure of added risk control investors may want to consider.

 

To help manage credit risk, diversify your income portfolios through an active solution. Consider:

 

 

 


The information provided herein does not constitute financial, tax or legal advice. Always consult with a qualified advisor prior to making any investment decision. Statements by the portfolio managers represent their professional opinion, do not necessarily reflect the views of iA Clarington, and should not be relied upon for any other purpose. Statements that pertain to the future represent the portfolio managers’ current view regarding future events. Actual future events may differ. iA Clarington does not undertake any obligation to update the information provided herein. The information presented herein may not encompass all risks associated with mutual funds. Please read the prospectus for a more detailed discussion on specific risks of investing in mutual funds.

Interest Rate Risk

The risk of a decline in bond prices due to an increase in interest rates

Investors seeking income have traditionally turned to investment-grade bonds for the relative stability and conservative return profile that they can offer. And for much of the past 30 years, this asset class rewarded investors with reasonably attractive yields, plus the added benefit of potential price increases due to the long-term trend of falling interest rates (Chart 1).

 

Chart 1 – Historic decline in interest rates helped drive total return in bonds

Historic decline in interest rates helped drive total return in bonds

Source: Bank of Canada, April 30, 2017.

 

But for the foreseeable future, investment-grade bonds may no longer provide the attractive total return profile that investors relied upon in the past. That’s because historically low rates on investment-grade bonds present two current challenges for traditional income-seeking investors. The first is that yields currently provided by investment-grade bonds may be insufficient to meet an investor’s cash-flow requirements, let alone outpace inflation.

The second is the risk of a decrease in bond prices due to a potential increase in future interest rates. Even a relatively modest rate increase could significantly affect the price of a bond, putting invested capital at risk (Chart 2). For example, a 1% increase in rates would see more than a 8% decrease in the price of a 10-year Government of Canada (GOC) bond. For a 20-year GOC bond, the decrease would be over 14%, and for a 30-year GOC bond, the loss would increase to 22%.

 

Chart 2: Investment-grade fixed income could be challenged if rates rise

Investment-grade fixed income could be challenged if rates rise.

Source: Bloomberg June 1, 2017.

 

The examples above illustrate the current interest rate risk associated with investment-grade bonds, which are more vulnerable to rate increases than in the past. This is due to the fact that bond yields are now lower, providing less income return while having a higher duration (Chart 3), which translates to greater interest rate sensitivity.

 

Chart 3: Interest rate sensitivity has increased

Interest rate sensitivity has increased

Source: PC Bond, a business unit of TSX Inc. Based on FTSE TMX Canada Bond Universe Index. This chart is intended to show the impact of a 100 basis point (1%) increase in yields. Total return estimate = yield to maturity + price impact of a 100 basis point increase.

 

Help reduce the risk

By diversifying sources of fixed income and moving into asset classes that behave differently and feature lower interest rate sensitivity (duration) and higher yield potential, investors can aim to lessen the impact of rising rates. Senior loans and high-yield corporate bonds are two alternatives that currently offer attractive levels of income potential relative to interest rate risk (Chart 4). When actively managed, each can play a role in a well-diversified income-oriented portfolio.

 

Chart 4: Yield and interest rate sensitivity

Yield and interest rate sensitivity

Source: Bloomberg, Credit Suisse and PC Bond, a business unit of TSX Inc. (April 30, 2017). Indexes used: Canada bond universe represented by the FTSE TMX Canada Universe Bond Index; investment-grade corporates represented by the FTSE TMX All Corporate Bond Index; Canadian governments represented by the FTSE TMX All Government Bond Index; senior loans represented by the Credit Suisse Leveraged Loan Index; high-yield bonds represented by the BofA Merrill Lynch High Yield Master II Index.

 

To help mitigate the risk of rising interest rates, diversify your income portfolios through an active solution. Consider:

 

 

 


The information provided herein does not constitute financial, tax or legal advice. Always consult with a qualified advisor prior to making any investment decision. Statements by the portfolio managers represent their professional opinion, do not necessarily reflect the views of iA Clarington, and should not be relied upon for any other purpose. Statements that pertain to the future represent the portfolio managers’ current view regarding future events. Actual future events may differ. iA Clarington does not undertake any obligation to update the information provided herein. The information presented herein may not encompass all risks associated with mutual funds. Please read the prospectus for a more detailed discussion on specific risks of investing in mutual funds.

Inflation Risk

The risk of erosion of purchasing power

Conservative income offerings, including investment-grade bonds, have long been a staple for investors to cover their income needs. But today’s income-seeking investors should be mindful of the inflation risk posed by relying too heavily on traditional “safer” income-generating options. Consider that a Government of Canada 10-year bond that is currently yielding 1.48% will actually provide a minimal “real” return, with inflation running at 1.60%.* This recent heightened risk is in contrast to what many investors may have experienced over the previous few decades.

In the past, a “bond ladder” strategy of holding government bonds that mature and are replaced over a sequence of years offered a reasonably effective way for investors to generate income and offset inflation risk. As the general trend from 1985 onward saw rates and inflation gradually falling, and an overall decline in real yields on traditional bonds (Chart 1), investors were still able to benefit from a ladder that held positions in bonds issued in previous years which had higher yields.

 

Yield 5 Yr Bond Ladder

Source: Bank of Canada, December 31, 2016. Assumptions: Bought a new 5-year Government of Canada bond every December when one matured. Real yield is nominal yield minus year-over-year inflation.

 

Consider an investor (Investor A) who retired in 1985 with a $1 million laddered bond portfolio, relying on inflation-adjusted withdrawals starting at $50,000 annually (Chart 2). The investor was able to generate cash flow at that level and still grow the value of the portfolio for close to twenty years. This in turn provided a healthy base for income generated in the future at lower rates. Contrast this with an investor (Investor B) retiring in 2000 with the same cash-flow requirements. With the onset of lower rates, modest inflation has been eating into this investor’s savings, resulting in a higher drawdown on capital and no portfolio growth. The outcome for an investor retiring today or in the near future looks even more concerning, given the general consensus for a sustained period of low rates for the foreseeable future.

 

Bond Ladder and Withdrawal Scenarios

Source: Bank of Canada, iA Clarington Investments, December 31, 2016. Assumptions: Bought a new 5-year Government of Canada bond every December when one matured. Initial investment: $1M. Withdrawal: $50K, inflation adjusted.

 

Help reduce the risk

Investors seeking solutions to help offset the risk of inflation eroding their future purchasing power may wish to consider including alternative income investments as part of their overall portfolio. These alternatives might include senior loans, high-yield bonds and dividend-paying equities. In addition to their historical profile of producing inflation-beating returns, these alternative asset classes all currently offer yields that readily outpace inflation (Chart 3). Investors considering these alternatives should note that the added yield profile of these alternatives does come with an added level of risk – particularly credit and equity risk. For this reason, investors may want to consider a diversified, active approach that seeks to overcome these risks.

 

Income Yield Chart

Source: PC Bond, Credit Suisse, Bloomberg and Bank of Canada (April 30, 2017). Government represented by the FTSE TMX Canada All Government Bond Index, bond universe represented by the FTSE TMX Canada Universe Bond Index, IG corporates (investment-grade corporate bonds) represented by the FTSE TMX Canada All Corporate Bond Index, Canadian dividends represented by the S&P TSX Composite Dividend Index, senior loans represented by the Credit Suisse Leveraged Loan Index (USD), and HY bonds (high-yield bonds) represented by the BofA Merrill Lynch High Yield Master II Index (USD). Inflation is CPI as of April 30, 2017. Source: Bank of Canada.

 

To help manage the risk of inflation, diversify your income portfolios through an active solution. Consider:

 

 

 


The information provided herein does not constitute financial, tax or legal advice. Always consult with a qualified advisor prior to making any investment decision. Statements by the portfolio managers represent their professional opinion, do not necessarily reflect the views of iA Clarington, and should not be relied upon for any other purpose. Statements that pertain to the future represent the portfolio managers’ current view regarding future events. Actual future events may differ. iA Clarington does not undertake any obligation to update the information provided herein. The information presented herein may not encompass all risks associated with mutual funds. Please read the prospectus for a more detailed discussion on specific risks of investing in mutual funds.

* Source: Bank of Canada as at April 30, 2017.

Currency Risk

The risk of loss from fluctuation in foreign exchange rates

Investors seeking income may look beyond Canada in their search for yield. Foreign investments can diversify choice, offering greater access to additional asset classes, higher yields or other opportunities not readily available in Canada. It’s a prudent approach that’s adopted by many investors with an appetite to expand their portfolios beyond domestic markets. While this may bring added diversity and opportunity, it also introduces added complexity through the potential for fluctuation in currency exchange rates.

Generally, when foreign investments are purchased, investors have to change Canadian dollars into the local currency of their investment in order to make the purchase. When the time comes to sell, the sale is made in the foreign currency and then converted into Canadian dollars. The change in the value of the Canadian dollar relative to that of the currency of the foreign investment can either add to or subtract from returns.

Common investment wisdom suggests that over long periods of time, the impact of foreign currency fluctuations may be negligible for investors with a long-term time horizon. However, for investors seeking to draw income, it is critical to manage the risk of loss due to exchange rate fluctuations.

This can be demonstrated by examining historical global bond performance using both a hedged (exchange rate fluctuations are managed) and an unhedged global bond index for illustration (Chart 1). Over 15 years, the hedged portfolio delivered a 4.9% annualized return, just slightly outperforming the unhedged version, which delivered 4.1%. However, the investor experience would have been quite different, with the unhedged bond index delivering substantially more volatility (standard deviation) over key points in time during the holding period (Chart 2).

 

Chart 1: Annual returns of hedged vs. unhedged global bonds

Annual returns of hedged vs. unhedged global bonds

Source: Bloomberg, December 31, 2016. Global bonds – unhedged represented by Barclays Global Aggregate TR CAD, global bonds – hedged represented by Barclays Global Aggregate TR HDG CAD.

 

Chart 2: Historic volatility of hedged vs. unhedged global bonds (standard deviation)

Historic volatility of hedged vs. unhedged global bonds (standard deviation)

Source: Bloomberg, December 31, 2016. Global bonds – unhedged represented by Barclays Global Aggregate TR CAD, global bonds – hedged represented by Barclays Global Aggregate TR HDG CAD.

 

When you combine the potential for increased volatility with the need for annual withdrawals, the negative impact that unhedged currency exposure may impose on an income portfolio becomes even more pronounced.

Using the same bond indexes for illustration, consider two hypothetical investors, each with a bond portfolio of $1 million, who plan to make annual inflation-adjusted withdrawals starting at $50,000. Investor A holds a hedged portfolio, while Investor B has an unhedged portfolio (Chart 3). After 15 years of annual withdrawals, the hedged portfolio has a value of $865,000, while the unhedged portfolio is worth only $506,000 – a difference of over $350,000. Faced with the challenge of funding several decades in retirement, managing the risk of currency fluctuation remains a critical need that has the potential to make or break investment outcomes.

 

Chart 3: Impact of withdrawals on hedged vs. unhedged bond portfolios

Impact of withdrawals on hedged vs. unhedged bond portfolios

Hypothetical example for illustrative purposes only. Source: Bloomberg, December 31, 2016. Unhedged portfolio represented by Barclays Global Aggregate TR CAD; hedged portfolio represented by Barclays Global Aggregate TR Hdg CAD. Assumptions: $1M initial investment with annual cash-flow withdrawals of 5% of initial portfolio value adjusted for 2% inflation.

 

Help reduce the risk

Investors seeking the advantages that foreign income investments may offer, while also wishing to minimize the related risk of loss from currency fluctuations, may want to consider an actively managed investment solution. Active mutual fund managers can oversee a strategy of full or partial hedging within the portfolios they manage. Depending on the skill of the managers and the mandate of the fund, they may seek to take advantage of anticipated and favourable currency movements as they arise, or instead they may maintain a full or partial hedge on holdings in an effort to dampen currency risk and focus primarily on security selection and/or asset allocation. The goal in all cases is to optimize the outcome for investors.

To help manage currency risk, diversify your income portfolios through an active solution. Consider:

 

 


 

 

The use of standard deviation as a measurement tool allows for a reliable and consistent quantitative comparison of historical relative volatility and related risk. Standard deviation is widely used to measure risk in terms of the volatility of returns. It represents the historical level of volatility in returns over set measurement periods. A lower standard deviation means the returns have historically been less volatile and vice-versa. Historical volatility may not be indicative of future volatility.

The information provided herein does not constitute financial, tax or legal advice. Always consult with a qualified advisor prior to making any investment decision. Statements by the portfolio managers represent their professional opinion, do not necessarily reflect the views of iA Clarington, and should not be relied upon for any other purpose. Statements that pertain to the future represent the portfolio managers’ current view regarding future events. Actual future events may differ. iA Clarington does not undertake any obligation to update the information provided herein. The information presented herein may not encompass all risks associated with mutual funds. Please read the prospectus for a more detailed discussion on specific risks of investing in mutual funds.