A few weeks back, I kicked off the Intelligent Investor Series as part of my weekly commentaries. Th...
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Income Funds: Getting the Balance Right
06/25/2012 8:15 am EST
Here’s a closer look at TD Monthly Income, one of Canada’s largest and most successful in its class, writes Rob Carrick, reporter and columnist for The Globe and Mail.
How to build an income portfolio:
- Mix 60% stocks and 40% bonds, or thereabouts.
- Use Canadian dividend growers for the stock part, plus a sprinkling of real estate investment trusts and income trusts.
- Use a mix of mostly corporate bonds for the bond component, plus some government and high-yield bonds.
That’s a quick summary of how managers Douglas Warwick and Geoff Wilson run TD Monthly Income, one of the largest and most successful income-focused mutual funds in Canada. If you want to know how to construct a portfolio to generate a reliable flow of investment income, you might as well consult the experts.
This fund has a default asset mix of 60% stocks and 40% bonds, but it’s allowed to stray a bit from that model. Today, the stock weighting is down a bit to accommodate a higher than usual cash holding.
Warwick, lead manager of the fund, said the 60:40 mix of stocks and bonds was found to offer the best combination of risk and reward based on extensive back-testing of returns. The biggest challenge with this mix is generating income from the bond side of the portfolio at a time of historically low interest rates.
"It’s getting more difficult in this environment to be able to get the income out of bonds, and it’s becoming more attractive to look at equities," Wilson said. For people who want to break out of the 60:40 mix, he suggested less volatile stock-market sectors like pipelines, utilities, and real estate investment trusts.
The 60:40 asset mix gave TD Monthly Income a loss of 23% in 2008, the year the Canadian stock market lost about one-third of its value. The five-year annualized return to May 31 was 2.5%, which compares to an average loss of 0.3% for peers in the Canadian equity balanced category.
Virtually all stocks in the portfolio pay a dividend, and the emphasis is on companies that regularly increase the amount of cash they pay to shareholders.
Dividend growth stocks often have comparatively low yields, but that’s not a problem for Warwick. "If you go for the highest yield, that’s often a stock that doesn’t go anywhere for years. It’s often better to accept a little bit lower dividend yield because people are willing to pay up a little bit for a stock that has some growth potential."
TD Monthly Income relies heavily on financial stocks to generate dividends. Financials were the top sector in the fund’s stock allocation, at 32% as of April 30, and Canada’s Big Five banks represented its Top Five holdings. Energy stocks aren’t often considered by dividend investors, but the fund had a 12.4% weighting in this sector.
Another 5.4% of the equity holdings in the fund is accounted for by real estate investment trusts and income trusts. RioCan REIT and Boardwalk REIT both appeared in the funds’ larger holdings as of April 30.
TD Monthly Income can invest in US and foreign stocks, but the managers have largely avoided them. One of the big reasons is currency risk, where fluctuations in the Canada-US currency rate distort investment returns. Some mutual funds use hedging to mute currency risk, but Wilson said there’s a cost to this that would eat into the income available to pay out to unitholders each month.
Some investors have looked to preferred shares to generate income, but Warwick doesn’t like their risk-return profile. He sees them as offering risk comparable to common shares, but without the growth potential. "Why not just buy the common equity? You have to accept more volatility in the short term, but in the longer term you’re almost always going to be better off."
TD Monthly Income typically holds 1% of its assets or less in cash, but today the weighting is 3.4%.
Warwick said the fund’s cash is invested in Treasury bills and short-term notes called corporate paper, which generate yields that are close to what’s now available from government bonds.
The high cash holding allows the fund’s managers to take advantage of stock-market declines. "We do think the equity markets are very cheap, and we are dribbling money into the equity markets as we see opportunities."
To help boost yields from bonds, the fund has about 6% of its holdings in high-yield bonds issued by both Canadian and US companies.
High-yield bonds are issued by companies with lower-tier credit ratings, and they’re significantly riskier than government bonds. The payoff is much higher yields than other types of bonds.
Most of the bond weighting is in investment-grade corporate bonds, which are issued by blue-chip companies. These bonds offer slightly higher yields than government bonds, and the additional risk is modest as long as the economy holds up. The remainder of the fund’s bond holdings is in a mix of federal and provincial bonds.
The main risk to bonds right now is an increase in interest rates. As rates rise, falling bond prices will put downward pressure on the value of a portfolio like the one in TD Monthly Income.
Duration is the key measure of bond sensitivity to interest rates changesâ€"it refers to the number of years it takes for a bond to repay its cost through twice-a-year interest payments and return of your investment at maturity.
The duration for the entire portfolio of bonds in TD Monthly Income is 6.5 years. That means these bonds would fall 6.5 percentage points in value for every point that interest rates climb (and vice-versa). The mix of bonds could certainly be changed if the interest rates move higher.
Globeinvestor.com shows that TD Monthly Income pays 3.05 cents per month per fund unitâ€"based on a recent unit price of $16.43, that indicates a yield of 2.2%. This includes the impact of the 1.48% management expense ratio.
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