On March 6, I wrote a column that discussed the history of markets after they have fallen 15 per cent. It said that returns had been quite strong, and based on that you should at least be holding your stocks, but probably buying more.
I took some heat for writing that, especially as markets continued to crater for another two-and-a-half weeks.
Today, the S&P 500 is up 5.5 per cent from March 6, and probably up six per cent including dividends. If you simply ignored the past three months, you would think that a quarterly return of six per cent is very good. Clearly, it is hard for anyone to have ignored the past three months, but there is a powerful lesson there. While the stock market doesn’t ignore today, it certainly puts it on mute. All investors would be better if they could do the same for today’s headlines (except this one of course).
The big question, as always, is what do I invest in now?
For the past three months we have definitely been looking to add to stocks as we thought there were bargains all over the place. Today, there remain sectors that are undervalued like energy and financials, which we believe will likely see some solid increases, but across the board, we no longer see a “pound the table” reason to increase stock weightings.
What does today look like?
We see balanced to maybe even slightly elevated valuations in stocks today in some sectors, dependent of course on how the economy recovers.
We see incredibly low interest rates that will likely stay low for an extended period of time.
We see traditional bonds as being an important but smaller piece of portfolios for safety, as yields are often going to be well under three per cent.
We still see some tremendous opportunities in preferred shares, where some blue chip companies have 10 per cent dividend yields that will be in place at least two to three years, and prices that have only partially recovered.
Like pension funds and foundations, we see tremendous opportunities in private credit that can deliver 7.5-per-cent-plus returns on a steady basis that are not directly linked to the stock market.
What does this mean for you?
The first step is to look at your long-term asset mix and you should probably be close to that mix today. If you are significantly out of step, then it is definitely time to rebalance. Hopefully, you didn’t make major shifts out of stocks over the past few months, but if you did, you should probably at least try to get closer to your longer-term levels.
The second step is to ask yourself if you need a new asset to add to your asset mix. Two of the areas where we see the best opportunities at the moment are in preferred shares and private credit. Do you have any money invested in either of these areas at the moment? If not, then it is worth looking at this further.
To delve a little deeper into preferred shares, these shares are ‘preferred’ to common shares because the dividend they pay either needs to be paid, or if not paid, it is effectively deferred and still owed to you. As long as the company remains in business, the preferred share dividends are an obligation that the company needs to pay. On the other hand, companies are free to raise or cut the dividends they pay on their common shares. Most of the Canadian market for preferred shares is made up of large blue-chip companies, with the big banks, big insurers and utilities, making up the majority.
At a high level, the market in Canada is split into fixed-rate preferred shares, which have a set dividend that doesn’t change, and rate-reset preferred shares. These pay a set dividend, usually for five years, and then the dividend is reset based on the five-year Government of Canada bond yield at that time.
Overall, preferred shares have been a weak investment for the past decade, in particular the rate-reset preferred shares. While there are a few reasons for this, the main one for rate resets is that interest rates have fallen, and as a result, the dividends paid have either been lowered, or are projected to be lowered at the next reset period.
An example of this would be Enbridge Series D. This rate reset preferred share will not reset until March 1, 2023. That means that for the next 33 months, it will pay 27.88 cents a quarter. At its current price the dividend yield is 9.94 per cent. If five-year bond yields go lower from here, it can hurt the price of these shares, but keep in mind that these Government Bonds are currently at 0.39 per cent, near the lowest rate in their history. Even based on this rate, if the rate was reset today, the dividend yield would still be over six per cent. If five-year bond yields rise from here, you will likely get capital gains on this Enbridge preferred share in addition to an almost 10 per cent dividend yield.
On the private credit side, there are a number of investments that are available for accredited investors, or through investment counselling firms.
In most cases, the COVID situation has only slightly affected returns for the best managed investments in this area.
Many investments that have had steady returns in the eight per cent annual range, have continued to see positive monthly returns, with year-to-date returns for the four months to April 30 being in the two-per-cent-plus range.
The private credit that we primarily focus on is lending to businesses at high interest rates, but with significant security and collateral (asset-based lending). The security often starts with hard business assets that are worth meaningfully more than the loan. The security sometimes includes personal guarantees from the business owner, including pledging their home. The security usually includes an ability to pull interest payments from the company’s bank account if they miss a payment. Because of strong lending covenants and active monitoring, default rates are extremely low.
Of interest, demand for these types of loans has been increasing as traditional banks are significantly slowing down any new lending during the current situation.
Given the consistency of returns in the eight per cent range, and lower interest rates on bonds and deposits, we see a big opportunity to invest in this asset class. Our firm has a fund that invests in a selection of our best ideas, significantly in the private credit space. We believe that with the steady investment returns the fund is targeted to generate along with its regular monthly income, this is even more appealing to investors today.
The key investing theme for today is that while you will generally want to go back to your long-term asset allocation strategy, the extremely-low-interest-rate world requires that you make a real adjustment to the assets you now include in your mix.
Ted is hosting a webinar on June 8 on Investing for Today, including how to include private credit investing in your portfolio. To attend the webinar, click here.