Many investors are holding a disproportionately high percentage of cash in their portfolios when both the bond and equity markets are indicating a lot of uncertainty.
The threat from rising rates has been replaced by the fear of an upcoming recession. Most of the recent economic stats in the US have pointed to an easing in inflationary pressures as measured by the latest CPI and PPI numbers. However, this past Friday saw strong employment growth and high wage inflation indicating that the breaking of the high rate of inflation may take a little longer to happen. In his last speech, Chairman Powell of the Federal Reserve implied that future interest rate hikes in 2023 may be more muted than have transpired so far this year. In other words, the rate of growth of interest rate increases going forward will lessen. Both equity and bond markets assumed that a Fed pivot was in the cards and drove valuations higher. However, Powell did point out that rates are still not likely to decline anytime soon, just not go up as quickly.
The US yield curve has continued to invert implying that a recession is highly probable next year. As of December 2nd, the 10-2-year US yield curve is a negative 77 basis points, declining further from last month’s negative 41 basis points. The length and severity of the recession is still up for debate. The head of the Bank of Canada was first on the mark by saying that rates are in the process of peaking.
High Interest savings accounts remain at 2.50% for EQ Bank and 3.25% at TD discount. While the savings account at EQ bank is insured under CDIC, I am not exactly sure this is the case with the TD account as it is an ETF. As you know ETF’s that invest in money market securities are not insured. However, the credit quality of TD Bank is almost as good as the federal government, so no worries there. I am adding a high interest savings account with Saven Financial, a division of First Credit Union. Their current rate is 3.75%. Saven’s eligible deposits in savings and chequing accounts in non registered accounts, are insured up to $250,000 through the Financial Services Regulatory Authority. Deposits in registered accounts with Saven have unlimited insurance coverage. Saven does require an initial investment of $25 to join the credit union.
It should be pointed out that the rate of interest on these short- term savings accounts can change at any time and that investors cannot rely on a stable level of income from them. However, they do offer stability and capital preservation in this difficult economic time.
It should be mentioned that CDIC insurance insures up to $100,000 per financial institution. If you have $100,000 your deposit is 100% insured, but not your interest.
There is a rush amongst many retail investors into GIC’s once again with rates rising to attractive levels. Currently EQ Bank offers a one- year GIC through the TD discount channel with a yield of 5.06%. If you go directly to EQ Bank online the 1- year GIC rate is 5.10%. But keep in mind that EQ Bank does not offer RRIF accounts yet, so you will need to go through your discount brokerage account to invest your RRIF monies in an EQ Bank GIC. They do currently offer RRSP accounts however.
I am only advising a one- year non cashable GIC. Liquidity is a real issue when compared to tradeable bonds that can be sold anytime. This is the main reason that institutional fixed income portfolio managers rarely invest in GIC’s. They need the liquidity that bonds provide to take advantage of market opportunities when they develop. Purchasing a 5- year GIC does not offer that flexibility and consequently most money managers rarely use them.
Some investors are now considering extending term with rates having risen so much recently. Many years ago, in 1982 to be exact, I purchased for my Dad a 30-year Ontario Hydro bond when the current level of rates was well in excess of 10-12%. In one year, I sold that bond for a total return of 30%.
Today the situation is quite different. Interest rates have been trending down for decades and have only recently moved up as a result of escalating inflation. While I believe that rates and inflation are in the process of peaking, that does not mean that rates will back off sharply anytime soon. There is also a lot of debate as to the severity of the upcoming recession. Most strategists believe that this recession will be milder than the one in 2007-2008 given that banks are in a much stronger financial position today. If this turns out to be the case, rates will fall from current levels, but not to the extent that occurred during more serious economic downturns.
Consequently, I only recommend investing in 1-3 year domestic investment grade corporate bonds. Yields in these investment grade bonds range from 4-5% depending on the credit rating of each issue in addition to the term. I also continue to recommend a 1-5 year Government of Canada bond ladder, but have replaced the 1-5 year corporate bond ladder with the 1-3 year investment grade bonds.
Both in Canada and the US, high yield, poorer credit bonds have seen yields climb back up, but not to the high levels seen in the recessions of 2008 and 2020. Taking into consideration that a recession is highly probable next year, I do not recommend high yield bonds at this time with credit spreads expected to widen further from current levels.
Given that interest rates are peaking, I am removing floating rate ones from my model portfolios.
Lastly, I continue to avoid rate reset preferred shares. While they should have moved up in this period of rising rates, they unfortunately did not. Preferred shares are normally of inferior credit quality to bonds and have been negatively affected by this. Also, rate reset preferreds will not perform well should interest rates start declining in the future as their interest rate is reset every five years from the initial issue rate.