Five ways the wealthy preserve their fortunes

Share

For most investors, growth is the name of the game. For the wealthy, though, it's more about wealth preservation. They likely already have enough capital to meet their needs and then some, and their goal is to protect that.

Yet the old methods of preservation – namely owning long-term government bonds – no longer suffice. The low-yield environment puts future purchasing power at risk as returns on fixed income can't keep pace with inflation.

To keep rising prices from eroding their wealth, high-net-worth investors often steal pages from the playbook of institutional and ultra-high-net-worth investors. Here are some of these strategies.

Customized bonds

Any investor seeking to preserve capital needs fixed-income products to provide steady income and counter the volatility of equity markets. Yet high-net-worth individuals have the luxury of creating customized portfolios of bonds that can focus on specific strategies, says Dave Holt, a Winnipeg private-wealth counsellor with Pavilion Investment House.

"For example, if you have a taxable account, you might want to select bonds that throw off less current coupon income and can be purchased at a discount," he says.

This strategy effectively generates less interest income because some of the yield comes as a result of the lower market value of the bond. "Buying bonds trading at a discount effectively means that you're paying less tax in every period and then whatever the discount is becomes a capital gain when the bond matures."

Only 50 per cent of that capital gain is taxable, compared with interest income, which is fully taxable.

This strategy requires plenty of capital to hold multiple bond positions to ensure the portfolio is well diversified. Credit risk is also a concern, because this strategy involves buying corporate bonds below investment grade, Mr. Holt adds.

Private enhancers

Private debt and equity have been popular with institutional investors for more than a decade, and high-net-worth investors are now catching on, too, says Diana Orlic, a wealth manager with Orlic Harding Cooke Wealth Management Group, of Richardson GMP.

One upside is private investments have low correlation to public markets. For example, if the stock markets fall, a private equity investment will likely be less negatively affected because it does not trade on an exchange. Private debt and equity can thus "provide a more streamlined source of income and higher returns," she adds.

The downside is they are generally illiquid, so you cannot unwind the investment quickly if you require the money, or you may face "large penalties in any early redemption." These investments also require larger sums of capital, which investors need to ensure the allocation is diversified beyond one or two deals.

Interest diversification

In addition to spreading risk across asset classes and geographies, investors can also diversify across the interest-rate spectrum in their fixed-income holdings.

One option is laddering, which uses bonds of varying maturities to help manage interest-rate risk.

But investors can also protect against rising rates by including floating-rate bonds in the portfolio. "The benefit is the coupon floats, so if interest rates move up, then the yield on the bond would be moving up commensurately," Mr. Holt says. Of course if rates go down, so does the coupon of the floating rate bond.

If investors buy corporate issues, however, which have higher yields, these are typically rated below investment grade and come with credit risk. Investors thus need an advisor adept in analyzing the corporate health of the issuer's underlying business. As well, investors typically need to buy these bonds in larger blocks to make them economical.

Mortgage money

Rather than lending to governments or corporations, investors can lend to the real estate market.

One way to do this is through mortgage investment corporations (MICs). Ms. Orlic says MICs "provide access to short-duration, high-yield mortgages … which pay out 100 per cent of their income as distributions to investors."

MICs include several sectors of real estate, including residential, commercial and construction mortgages. One advantage is that high-net-worth investors can increase their real-estate holdings, earning a higher yield than fixed income without the complexity of managing a real asset.

While some MICs are publicly traded, many high-net-worth investors look to private-market versions that involve less price volatility and higher yields in exchange for less liquidity.

Among the risks are that MICs often focus on the higher-risk, unregulated mortgage-lending segment in Canada to provide that higher return. This requires a higher level of due diligence than if the investor were buying a bond.

Moreover, MICs carry two major risks that all Canadian real-estate investments face: high property valuations and high debt loads.

Hedging to reduce risk

Many advisors of institutional money turn to hedging for "insurance" on their fixed-income holdings, says Phil Mesman, a hedge fund manager with Picton Mahoney Asset Management.

One of the biggest risks they seek to insure against is rising interest rates. To hedge against that risk, for example, on a corporate issue yielding 3 per cent, the strategy might involve shorting a government bond, yielding about 2 per cent, with a similar duration.

"So if I bought $10-million worth of Shaw bonds, for example, it would probably have $7-million of government bond risk," Mr. Mesman says. "I would short $7-million of government bonds."

The idea is that if interest rates rise, government bonds are more negatively affected. By shorting the government bond, the capital gain on that trade in a rising-rate environment would offset the loss associated with the rate hike on the corporate bond holding.

"The objective here is to keep the interest-rate risk neutral" on the corporate bond holding, Mr. Mesman explains.