The world has changed a lot in just the past seven months. If you recall, back in January, the North American economy was incredibly strong, unemployment was at record lows, and most people expected the good news to continue. But that’s not how 2020 panned out, is it? It’s been quite the whirlwind, and we appreciate that everyone is nervous about the volatility of investing in the stock market. However, all that being said, with the way the past seven months has unfolded, our long-standing perspective on the appropriate portion of fixed income investments in your portfolios has been absolutely reinforced.
At the beginning of this year, we created the Baskin Fixed Income Pool as a more efficient way to manage your fixed income investments. With over $230M of fixed income investment in our fund, clients should see better returns as they benefit from increased buying power and diversification. Our objective for investing in fixed income is about as straightforward as it gets: Don’t lose money. We want our clients to enjoy low volatility, high liquidity and reasonable returns when investing in fixed income. So, by design, we are always very cautious with our fixed income approach.
Seven months ago, our biggest concern about fixed income was the risk of rising interest rates. With interest rates already so low in early 2020, and with the outlook so strong, we believed that rates were likely to begin to rise. When interest rates go up, the price of long-term bonds has to go down to entice new buyers; they provide better interest rates than the safer products, like GIC’s or money market funds. As a result of our concern, we kept the maturities of your fixed income investments very short. In doing this, we intended to reinvest the cash from maturing bonds into ones with better future returns. However, during a global pandemic, this did not play out as planned. As we all know, interest rates were cut to zero by central banks around the world, making bonds with longer maturities much more attractive and more valuable, than the bonds with short maturities. On an absolute basis, we are pleased with return of the Baskin Fixed Income Fund since the end of January. The Fund is up 2.8% to August 18th. However, that pales in comparison to the returns this year on bonds that have much longer maturities.
But that was then, and this is now. Every day we get emails with bond offers from various banks and institutions. For example, just last week we got an email offering to sell us a bond from the Province of Ontario with a maturity of seven years that delivers a yield of 1.05%. After that seven years, your original $100 would grow to $103.50. At that rate of interest, your investment doubles in 139 years, not taking into account fees, taxes and inflation. Even if interest rates do not rise, which they surely will sooner or later, this bond is a money losing proposition, and needless to say, we are not interested. However, even the other bonds that we have purchased recently hardly offer future returns worth bragging about. Decent quality bonds offered by Canadian companies pay about 2% to 2.25% per year for the next seven years.
We could be a little frisky and try and get 3% or higher, however, any Canadian company that is currently offering 3% a year comes with default risk. We don’t feel that getting 3% a year, before fees, taxes and inflation, compensates us for the risk that the company could go bankrupt. After all, remember the objective I mentioned earlier: Don’t lose money. This year will be remembered for the number of large, formerly valuable, companies that have gone broke leaving their bond holders in the lurch. They include names such as Hertz, JCPenney and Neiman Marcus. In our 28 years in business, we have never held a bond that defaulted on interest or principal.
So, now you can begin to understand part of the reason why the stock market has recovered so significantly in 2020. There really aren’t any reasonable returns in fixed income for quality buyers. This does not mean that one should sell all their bonds and buy stocks. Bonds are, and will continue to be, a shock absorber and source of liquidity and security in your portfolio. They can be a much-needed pacifier when market volatility rears its ugly head. Depending on your needs for liquidity, time horizon and risk tolerance, bonds may be a necessary part of your portfolio. But given the risk versus the potential rewards going forward, for many clients, we maintain that owning a significant amount of bonds is less necessary today.