Blogs & Comment

Asset allocation for 2012: Fixed income

A cautious approach to the start of the year calls for an increase in fixed income allocation.

In “Asset allocation for 2012: Cash,” I have recommended that investors carry only the strictest minimum allocation to cash in their portfolios to start this year; nothing beyond what is necessary to pay trading costs, fees and other incidentals. Now we’ll move on to the other two major asset classes: fixed income and equities. In both cases you’ll note the approach is cautious, not aggressive, as appropriate for these times.

Fixed income: Add 10% to your normal fixed income allocation right now.

While it depends on your investment preferences and constraints, a ‘normally-weighted’ balanced portfolio typically has a standard allocation of 10/40/50, which is 10% cash, 40% fixed income securities, and 50% equities. My current recommendation for cash is a 5% allocation, and for fixed income an extra 10%, so a typical balanced investor, following that advice, would go with a 5/50/45 allocation right now.

Why the extra 10%? I see four reasons. First, we are dealing with multi-generationally and historically low interest rates on cash. In a bid to seek a somewhat better yield, we can move some of that cash into fixed income securities.

Second, rates aren’t just low; we have been enjoying unprecedented clarity from the Bank of Canada, and now from the Federal Reserve as well, that there is only a negligible chance that administered interest rates will rise at least before the year is out, and possibly into 2014. Therefore, the price risk of fixed income securities is low, and in turn the incremental yield over cash is worth the risk of an extra 10% allocation.

Third, in my judgement the credit spread between government and corporate bonds is very low. In essence, if correct, this means there is less price risk in government debt securities than corporate fixed income issues, and therefore the extra 10% should largely be made up of government bonds rather than corporates and preferred shares.

Fourth, stock markets around the world are off to a great start in 2012, with the S&P/TSX Composite Index up 4.28% in the first four weeks. If you annualize that, you’ll see how unsustainable that pace is. Equity investors are feeling very optimistic right now, even though the problems that plagued their thinking mere weeks ago are still there (last year the TSX fell over 11%—was that so long ago?). Over a longer period than just the first month, I believe stocks are still an iffy proposition for 2012. Taking 5% off the stock table and putting it into fixed income seems prudent right now.

Bottom line: Whatever your normal allocation is, add 10% to the fixed income portion, equally at the expense of your cash and equity allocations (5% each). Preference should be given, in the extra allocation, to adding governments versus corporates. If that’s not aggressive enough for your tastes, you could always make the governments provincial issues, and the corporates preferred shares, in which case I advocate straight preferreds over floating rate issues right now.

In terms of duration, an average of between short and medium is recommended. If you’re still following last year’s recommendation, you would be 40% in fixed income right now, equally split between governments and corporates, and with a short average duration, so the current recommendation is somewhat different.

Equities: By default, we are looking at a 45% overall allocation to equities. This might be split 20% Canadian, 15% U.S. and 10% international. Despite the rocking start to the New Year so far, I remain concerned about the near-term future for equities. After all, the European debt situation, the U.S. gridlock, and the worries about a double-dip recession haven’t disappeared from reality the way they have disappeared from the news and many investors’ minds in the last four weeks.

Bottom line: My recommendation for Canadian issues is to concentrate in the banks and other financials, utilities and telecoms at the expense of other sectors such as consumer staples and consumer discretionary stocks. I don’t follow metals and mining stocks, or technology stocks, so you’re on your own there.

As always, blue-chip large-cap dividend payers are preferred. For U.S. and international exposure, one each of comprehensive traditional exchange-traded funds is a good passive choice.

We’ll look at this recommended allocation again in about six months to see if it’s been, and still is, appropriate. For now, at least you have a cautious blueprint, which is assuredly better than not having one at all.