Tuesday, April 13, 2010

Spread ‘em

I previously posted that 3.60% would be a benchmark for 2010 with respect to the Canadian bond market.

Recently, the 10-year benchmark has surged passed this yield- higher than 3.7%- and is currently sitting at 3.66%.

What does it mean to me? Do I think interest rates are clearly on a path upward? Do I need to sell my longest maturity bonds in order to avoid destruction in my net worth?

1) It means a great deal, I believe that the Canadian bond market and bond markets around the world are still sitting at the turning point created by the financial crisis.

2)I think it's wrong to predict with certainty the direction of this and that security. I think the shape of the yield curve is just as important as the nominal benchmark yields

3) I don't need to sell any of my bonds because I don't have any maturities longer than 9 years right now and I own only a moderate allocation (less than 10%) of my portfolio at those longer maturities.


At the end of March, the US Fed Reserve Bank ended its purchasing of housing bonds and other short-term bonds, and US bond markets sold off dramatically. The US 10-year yield moved from close to 3.6 to 3.98% in a matter of weeks and there was worry about the ability of the US to finance its debt with elevated rates and premature economic growth. The next week a hugely subscribed auction reinforced positive sentiments in US treasuries and the 10-year benchmark is currently trading closer to 3.84% and has been rallying to head back below 3.8%.

Canada is still tied to the US and so are all the financial markets. Thankfully, Canada is not tied to Greece and Europe. But when the fundamentals and the perception in the US changed with respect to the 10-year, it did likewise in Canada (the 1-year and 2-year have behaved in a different manner previous to the US sell-off, along with the currency).

Since the end of March, yields have moved from close to 3.5%, past my previously mentioned benchmark of 3.6%, and are now to closer to 3.65% over the past week or so.

Was 3.7% a good time to buy? Compared to December when 3.6% seemed like a lot, I suppose, but only if you are buying solely government bonds. I'll talk later about why this change wasn't the buying opportunity for corporate bonds that December 2009 was.

It all relates to a crucial factor that amateur investors, advisors and even some professionals routinely miss.

It has nothing to do with the stock market, though it is related to corporations.

The spread between all the various sectors of the corporate bond market have reacted in an enlightening fashion for the astute observer.


Clearly, the central bank has changed its intention with respect to interest rates and the Canadian dollar. The gradual ascent of the Loonie has allowed many businesses to cope with the currency exchange and to retool and increase productivity for the first time in ages. The markets have demonstrated anticipation of a 50pbs rate hike on short term Canadian treasuries within the next six months. If the economy and currency continue to enjoy a post-Olympic golden aura and the price of energy and commodities continue to rise, its possible short term interest rates could rise more than a full percent, or at least 100 bps. In this scenario 2-year could = 2.8-3.3%, 10-year = ?


The 3.6% benchmark that I called in December is important because 10-year benchmarks haven't had the same dramatic shift that Canadian 2-year yields and US 10-years have had.

The key feature to focus on is the average yield of 10-year corporate bonds and their spread from the government benchmark. Back in December, the spread was still contracting about 20 bps every three months. Meaning on average corporate 10-year investment grade bond yields were declining .2% in interest payments. Now, that spread has stopped contracting.

If you purchased a bond in the recent sell-off, you were not being rewarded any extra capital gain for keeping your money in 'riskier' corporate bonds, though the value of your bonds has held up even stronger than the 10-year government bond if you already held a 10 year bond.

This is important for my bench mark prediction, because when the 10-year reached 3.6%, it's the same moment when yield spreads on corporate and government debt stopped contracting.

While the value of long-term bonds has been decimated this month, my corporate bonds have all kept their value, suffering 1-2% declines at most. Industrial and real-estate bonds have increased in price almost 5% during this time. Will they keep rising for those wishing to build a portfolio now? It's possible, but it's better to observe and understand the market before investing.

Understanding the spread changes (or lack of) tells me that things are about to change in the bond market. My intuition tells me rates won't necessarily rise as much or as evenly as people currently think. 100bps is a lot of central bank tightening to do in 12 months. But Australia has a 4.5% short-term government rate... nothing is impossible with a resource-rich, stable, diverse, robust and productive economy- Canada, eh.

Does it mean buy, sell, hold? I've said since December that holding off from buying bonds unless the deal was too sweet is prudent. The bond market has been giving the signal to wait (the signal is when you have no idea what the signal is) and I think it remains a wise strategy. Still, intuition tells me there will be periodic buying opportunities. Likely around end of May, June or July when older debt matures and corporations seek to roll over the debt, and when a rate hike is being talked about as if it's already happened in the news. As for selling, do it if you own something longer than 10 years in maturity. There is hidden risk in 20 and 30+ year debt that the average investor doesn't consider. In my opinion, long-term bonds have as much risk in this economic climate as hedge funds, mortgage backed securities, derivatives, ACBP, CDOs, etc. There are simply too many unknowns in every market place to plan past a possible 2nd Obama term. My intuition and the evidence point me to believe that interest rate hikes will be slowly incorporated into the global recovery, allowing for short and medium term bonds to simply mature before reinvestment.

But just imagine if short term rates rise to 3%, and you purchase a 10 year bond this year for 3.5%? In one year you would have a 9-year bond, yielding 3.5% when it's possible that a 3-year bond could offer a similar yield. The value of your bond would be adjusted to match the equivalent 9-year market prices and yields. If the yield curve remains steep, long term rates will rise and if you tried to sell, you could be decimated.

Just be careful, and for the love of god, don't buy a bond fund.

Wednesday, March 3, 2010

Ahead of the curve

The Globe and Mail has now reported the recent bond sale by Brookfield Asset Management.

I just learned from this article these bonds can be redeemed if the company suffers a credit rating downgrade.

That's a pretty safe feature and highlights another 'can't-lose' aspect to this bond issue which made it so attractive for individual investors.

The fact that I can report this story on my blog the day before a major financial reporting blog, with more detail and context, is due to two factors.

First, a skilled, experienced and involved investment advisor is a necessary precondition for developing a deeper knowledge of the investment community.

Second, my own willingness to follow the flow of information in fixed income markets and a willingness to interact and work with my investment advisor.

A skilled and connected advisor has years of experience working with markets and traders. They manage hundreds of millions and sometimes billions of dollars over decades. They protect the wealth of their clients during market crashes and they earn real, positive returns over the long term. In essence, they have seen people make millions and seen people go broke. They have survived and grown a large book of clients because they are stable wealth managers. They have the best ability to contextualize a clients personal needs and the financial environment within which they are living (ie. They understand better than most, through hands on experience, how the yield curve and interest rate cycles affect prices and yields for products and securities).

Having your own passion for knowing about the bond market isn't the easiest thing to have. It's something that usually happens late in life when you've finally tried every crazy scheme to make money and failed. Following the bond markets opens up a new world of medium and long-term investing where risk and return have inverted meaning compared to the mass-marketed, stock-market oriented education materials. The hidden world of Over-The-Counter (meaning corporate bonds are sold to retail customers privately- there is no central exchange to list sale prices for corporate bonds) fixed-income securities might seem to resemble a shadow cult, capable of mobilizing vast sums of money and deploying them for purposes of world domination. That might seem like something ridiculous, boring or unappealing for many forward thinking and capital gains/dividend-growth oriented individuals. The mainstream press would have you absolutely convinced half your savings must be in stocks and that bonds cannot be risked against stocks and must be kept in government securities. You must go out of your way and work to understand how you can personally take advantage of the bond market.

Without the willingness to reject a path-of-least-resistance way of thinking and investigate the real nature of the financial markets, and then applying that knowledge with a carefully selected advisor, the DIY investor will always be a day behind the headlines. Any individual who takes the time to find a skilled advisor (they can be young and well-trained, too), to educate themselves about the bond markets, and build a successful relationship with their advisor is truly ahead of the curve.

Tuesday, March 2, 2010


A-rated and BBB-rated investment-grade corporation.

5.2% interest for 6 years, a 5 year GIC yields approximately 3%. If interest rates remain relatively low, even if the bank of Canada raises its key lending rate by .25% every 8 weeks until it reaches 4% or 5%, this bond is of such a short term that it will likely never trade lower (at least not significantly lower) than it's par value.




Brookfield Asset Management has emerged from the global recession as a relatively strong company, according to recent press.

The executives of Brookfield are using their position of liquidity and prosperity to make up for previous losses and generate increased revenue and profits in the future. In order to increase profits they are buying properties from distressed and bankrupt sellers in the hopes of obtaining deeply undervalued properties and companies.

Some of the distressed properties and companies that Brookfield is pursuing carry long term debt. Servicing and repaying that debt was part of what led to the failure of these properties and corporations. Since a smaller, insolvent company cannot borrow money at any reasonable rate for any reasonable amount of time, the executives of Brookfield can use their investment-grade credit rating to roll-over the outstanding debt at a rate that satisfies the demands of fixed-income investors while keeping the debt service payments that Brookfield is assuming from rising. In this situation both the lender and borrower benefit and more economic activity is sustained overall and more money is made for all parties, than if the bond market had not been utilized.

Unless of course, the new properties and businesses that Brookfield purchases turn out to be less profitable than they anticipate. In that situation, Shareholders would realize dramatic decreases in earnings per share and suffer steep losses. Bond holders would keep their senior notes for 6 years and take their guaranteed interest payments and evaluate the company again when the bonds mature.

It hasn't been reported, but I know for a fact that this bond issue was sold out in approximately 3 minutes. That's all the time that the different banks not named RBC and CIBC had to decide if they were going to take a piece of this action. In this modern age of instant information, 3 minutes is hard to contextualize. Normally, new issues will be available for days or weeks (depending on market volatility and credit ratings). Compared with other 10 year bonds, yielding similar coupon payments that were floating around in December without a buyer in sight, 3 minutes tells you that there was zero doubt that this was an attractive investment product for any prospective buyer.

How do you get in on a deal like this? You have to have a good advisor who understands and works with the fixed-income desk regularly. Equally important, you have to work with your advisor regularly so that they are thinking about your account and your needs when new issues arise.

Tuesday, February 16, 2010

February blues... Bombardier is waiting for you to ask for less money... wait for them to capitulate.

The US indexes are at flat price levels since the beginning of the fall of '09 while the US dollar rises in value as European investors are feeling the effects of unsustainable debt levels post-meltdown.

The TSX has remained above 11000 while the benchmark 10 year government of Canada bond is trading with a yield as low as 3.35% (on February 8th 2010) and as high as 3.6% just a few weeks prior to that. It's clear that the end of the year (around Christmas) was a buying opportunity relative to the past 6 weeks and will likely be a benchmark for the year ahead among bond vigilantes.

The governor of the Bank of Canada has reaffirmed there is no need to raise interest rates because of the high value of the Canadian dollar and the weak demand from our largest trading partner, the US.

So what to do if you missed out on a chance to buy bonds when they were on sale at the end of 2009, you don't have confidence investing in the stock market and you don't consider yourself a 'gold-bug'?

Taking a look at the corporate debt market in Canada on a regular basis is a necessary ingredient to constructing a top-performing and investment grade portfolio. I've expressed often the need to wait for the right opportunity to strike and the ability to accept having missed buying opportunities. Here is a link to an article about the current pullback from borrowers who are immediately facing higher costs.

Waiting for the next right opportunity is critical. Often, unsophisticated and sophisticated investors alike will regret their inability to make an attractive purchase. Faced with this deficit of opportunity cost, the unwise investor is prone to seek out the "next-best" alternative. Be it a competitor or an 'uncorrelated' security. The unwise view their time and labour as wasted the moment they become aware of a missed opportunity. This emotional response then triggers a panic reaction, where no further time can be allowed to waste while cash is "sitting on the sidelines" and "earning you nothing". Once the emotional responses have kicked in for the unwise investor, they are on a self-fulfilling path of hasty decision making.

The "next-best" choice is one which is typically not on the radar of those who miss an opportunity but quickly becomes the sole focus of the unwise investors' attention. Because there is this view of opportunity and time already having been lost, a clear decision has to be made as soon as absolutely possible and hence little time is given to the vigorous research that was given to the original opportunity.

Needless to say, an investment that is not prudently researched and investigated is not called an investment, it is called speculation. Unwise investors doom themselves to poor returns because of a failure to properly understand the nature of what they are investing in and the current market conditions within which they find themselves. The sophisticated and experienced investors of this world take a different perspective on the nature of the time they devote to selecting their particular investments.

To the wealthy and powerful, the reality is that most deals- be they good, bad, awful, average or fantastic- most deals simply cannot be finalized. Staying power is a necessary precondition to achieving your objectives for this reason. If you seek to create a sustainable development project, if you wish to run a hedge fund or sell commercial real estate- the only way to truly be considered a success is to be able to self-perpetuate your operations indefinitely and withstand the missed opportunities that occur. Staying power is a tool for a successful life, investment career or business because of the dynamic nature of society, where opportunity is continually (though irregularly) available.

back to the Canadian bond market:

My investing strategy with respect to provincial, municipal and inflation-protected bonds has shifted dramatically from last year. At the height of the financial meltdown, provincial bonds with a 10 year maturity were available with interest rates approaching 6%. Currently the yield on most provinces is around 4% for a 10 year bond. Consequently I'm enjoying a period of my life where I would rather trust my savings and investments with bonds in investment-grade corporations rather than governments. The current situations with Europe and Greece and Dubai have all confirmed the ongoing frailty of the entire global system of finance and the frugality with which every investment must be vetted. Canadian government and agency debt (though safe) is extremely expensive (meaning substandard future returns) relative to historical standards.

Strategically, I'm currently holding more interest bearing cash (no money market funds of any kind, just cashable GICs or equivalents that offer total security, liquidity and some positive return, however minimal by historic standards). I'm watching as companies like Bombardier are waiting for the right time to enter the bond market. Some will be forced to come to the market for various reasons and it will be interesting to see how willing corporations will be to sell bonds. If it's possible to gain 5-7 year bonds from corporations like bombardier that are paying close to 8.5% in coupon payments, it is a tempting offer- just not for Bombardier shareholders. It would mean that they would be forced into setting aside millions of dollars of extra cash for interest payments, which would have an overall effect of reducing earnings for years.

Rising interest rates are bad for borrowers (corporations and individuals alike) and good for lenders. While you might face a financial statement that has dropped in value if you already own a large amount of bonds, if you have a lot of cash on hand, you will not have to realize any losses and your entire principal is still promised to be returned upon maturity.

Typically I would anticipate that corporations and governments alike will begin to capitulate throughout the remainder of the year. Credit is like the blood flowing through the organism that is the global economy. Greece, Dubai, Europe, America- They all run consistent deficits. The only way they can remain functional states is through selling bonds every year (corporations typically sell bonds for extra 'no questions asked' cash that they can use for any purpose management deems fit). As complex rescue packages, austerity programs and corporate downsizing all continue to improve short-term growth, they can't overcome the reality of historic losses and record debt that require significant financial restructuring.

The lesson should be self-evident as it is a self-reinforcing principle of human psychology and behaviour. As time goes on, and the difficult choices and legislative reforms are slowly and bluntly moved forward, the negative environment will continue to reinforce lenders' attitude that the inability to fully resolve debt increases the risks associated with that debt. Increased risk requires increased reward; it's as simple as that, it's why I find myself largely waiting out the winter, and why corporations are leery of selling bonds when they see their competitors are now required to pay more to borrow. The only problem is that enterprises need credit just like cells need blood. Eventually, every corporation and state with debt will seek out financing as a necessity of its daily or future operations. If you are patient enough to wait, you can seize an opportunity to buy bonds that clearly benefit the lenders, while simply satisfying the need of the borrower. The prime caveat is that you need to also have the confidence your borrower will be able to pay every coupon on time and ultimately repay your principal on the date of maturity.

You should be aware that in the above situation, an investor in common shares, or someone who now buys an ETF that mimics the major indexes, will likely see zero earnings growth, zero capital appreciation and a small dividend that increases at or below the level of inflation.

Thursday, December 24, 2009

The slippery slope of the yield curve

The year end market activity and news around the world is fascinating right now.

The benchmark 10 year yields for Canadian savings bonds has moved from approximately 3.25 to around 3.6 today. The move has taken about two weeks. Central bankers have confirmed that they will set overnight borrowing rates at near zero for at least 6 months to a year, so we should expect long term interest rates to remain low. They also expect inflation to be a non-existent factor for the average citizen.

If any of that is actually true or not is only verifiable in hindsight, but for the time being, it is what the best evidence leads one to believe. If the programs and expectations of the various central banks of the world develop more or less as they are anticipating, what does it all mean heading into the new year and what will happen to the bond market?

What will this mean for the DIY bond investor?

I previously mentioned that I turned down a 5% interest 10 year corporate bond. The bond has dropped 2% in value to 98.2 and the yield has subsequently increased to 5.3%. It's not a staggering change, but it's enough of a swing and in such a short period of time that it warrants attention.

Buying long-term bonds carries the increased risk that interest rates could rise rapidly in the short term and the relative value of your bond will decrease significantly in this situation. The 100 face value of your 5% bond is cut in half when there are new bonds on the market of similar duration that offer 10% interest. Your 100 dollar investment will be redeemable before maturity for only 50 dollars. If you are unable to hold to maturity, or if the dramatic decline in price of assets causes the issuer to default, you could lose big.

That's why I turned down any 10 year bond I was offered. I did once accept a bond that was investment grade, 10 years and yielded 7.95%. I don't care what happens, that is always a healthy rate of return and it's unlikely the value will ever fluctuate greatly, but that was a lucky break.

When speaking about the average DIY investor, trying to save up for his retirement, the strategy is simple. Credit spreads between corporate and government bonds and high yield bonds have all returned to pre-crisis levels. The yield curve is as steep as it has ever been and the past two weeks have returned the bond market to one of the steepest yield curves in history. The stock market, particularly financials and commodities (as this makes up most of the Canadian economy) have mostly kept the gains made from march-august but have mostly seen much more modest to zero gains since then. Natural gas prices have steadily, if unevenly reverted back to seasonal and cyclical price increases.

In this environment the DIY investor is wisest to stay away from investing in any long duration bonds. Corporate bonds are very expensive relative to the prices available last year and up until august 2009. With the United States treasury gearing up to roll over an estimated 2 trillion dollars of debt via auctions, it is likely that this recent rise in long term yields could be a precursor to a much more significant and long-lasting rise in interest rates.

If this is true, then the next sixth months could be a period to stay on the sidelines or to stay in cashable GICs, waiting for a better opportunity to present itself (and it will). During this time, the DIY investor should just stay informed and remain interested in the news and the various bench mark prices, yields and maturities. Further research into the debt structure of the corporations you hold bonds with will help further refine your criteria and ability to spot a bargain in the corporate debt market.

And if the DIY bond investor has managed to make some money with the stock market, it might be an interesting time to take a chance on some small-cap investments and look for capital gains. Investing in large cap, dividend payers, is a good idea unless you are buying at the top of the market. Because most indexes around the world have been relatively flat since august, that makes for a much riskier investment, though there are always countless exceptions.

Friday, December 11, 2009

50%+ return, guaranteed... in ten years

Is it worth it to purchase an investment-grade bond that matures in December 2019, and pays 5.05% interest annually?

This is the question I faced recently. My advisor knew that I was interested in filling out the rungs on my bond ladder.

During a day of rising interest rates and hence falling bond prices he called to recommend taking a 5% holding in a single bond issue from a Canadian telecom company.

The bond is BBB with a stable or positive outlook. These companies have large subscription bases and steady cashflow. Default is unlikely or, more accurately, a very remote possibility.

So is this a wise investment?

Large money managers like pension funds and insurance companies love long-term returns in excess of 5% that are guaranteed because it makes covering their expenses infinitely easier.

Despite the difference in net-worth, the DIY investor faces a quality of life and peace of mind that comes from stable, guaranteed income that is similar to a profitable fund (manager).

While the large fund has pension benefits or liability claims that are often burdensome on the overall ability to create a profit, the DIY investor faces the many challenges of work, family, savings, trying to live and support a household, dealing with unexpected calamities, etc.

Both parties need stable income to overcome any ups and downs in the real world, and hence actually have a mutual affinity for the bond market and achieving yield in excess of the government benchmarks without being exposed to default risk.

But for the DIY investor like me, who has great bonds in the short and medium term and few bonds in the long term (5-10 years), I don't face the same pressures going forward that a large fund faces. I face the pressure of generating as much income from my employment as possible, protecting my savings from losing value, investing my savings in a way that will guarantee my principle contractually and include all interest payments.... that's all I need to be concerned with.

So this 10 year bond, 5.05% interest bond is sitting there, wondering if I'll put a relatively large sum of money in the company's hands for a full decade.

I decided to pass on the investment. While the cash is still sitting there perfectly safe and fresh and clean, it is not earning anything. I am ok with this. You can argue Canadian Dollars are worth 10% more now than they were a year ago, but that's not what we need to consider now)

Benchmark bond prices have suffered the occasional selloff and rally over the year and have provided some remarkable opportunities to make money using simple buy low sell high rules, trading the everyday bond issuers we see in Canada.

If this recent sell off is not part of a broader decline in bond prices, meaning inflation and/or market fears and debt fears are shaking, but not fundamentally shifting price support for bench mark bonds and industries and hence interest rates won't rise, I will have missed an opportunity. I will have missed at a chance to take advantage of a potential capital gains situation, or just simply enjoying a return that beats all the marketed products available.

If interest rates are really going up sooner and harder than we have expected, my money is now ready to be deployed to a medium term maturity and high interest rate, thanks to my ongoing study of the Canadian Bond Market.

If I had failed to study interest rate trends (once they hit bottom, they can only go up) and purchased a large bond issue right before interest rates start to rise, the value of my investment will be diminished. I'll likely never be able to sell without a loss before maturity because it will trade at less than 100 every day. To make it even worse, I wouldn't have as much money sitting around to purchase higher interest bearing bonds.

Be careful and remember: "he who fights and runs away, lives to fight another day"

Thursday, October 1, 2009


So if you like what you hear about guaranteeing the return of your principal and a 7% return, why not move more money into bonds.

This article will provide a brief overview of all the basics.

However, it's written for an American audience and I think there are a few important things to ignore:

1) ignore anything related to municipal bonds and professional management, the market place and advisors typically work in a different fashion in Canada with respect to the bond market

2) ignore the section which tells you that a minimum of $100 000 is needed in order to safely purchase individual bonds.

The reason for number one is simple: the tax codes are different in Canada and the US for municipal bonds- they are usually exempt from many taxes in the US.

As well, because the Canadian bond market is dominated by a small handful of financial institutions, the fee structure typically works differently for professional management. You typically pay a hidden fee that is included in the final price you pay per bond.

The reason for number two is the purpose of this post. If you pay attention to what I've written about here and here, I believe it is possible to safely purchase and invest individual investment grade corporate bonds in units as small as $5 000 for the individual DIY investor, using a discount brokerage.

The investor starting with approximately $5 000 - 50 000 dollars to invest in fixed-income will have two distinct advantages over any bond fund currently available in Canada

1) There are no bond funds which come with a guarantee to repay your principal by a specified date- this is a very important distinction if security, preservation of capital and the ability to sleep at night are a high priority for the investor (which they always should be, no matter how young).

2) Through careful and deliberate purchases of individual bonds (filling up one rung of the ladder each time you have new monies to invest), the overall performance of the investor's fixed income portfolio will exceed the yield offered by any bond fund by about 1%, or 100 basis points.

Number one is straight-forward, number two is a little more complicated but can be easily summarized:

1) Bond funds typically promote their suitability to retail investors because of their size, and their ability to diversify among issuers and therefore eliminate any credit risk or exposure to interest rate/inflation pressures. While this is generally correct, I've repeatedly made the case that laddering a portfolio of individual bonds can achieve the same effect.

2) Because bond funds are so large and because they are compelled to buy and sell more and more bonds, if not own all the bonds in the market (like some etfs), they always carry a large amount of bonds that are among the safest and therefore lowest yielding while incurring costs that are eventually passed on to investors, further diminishing yield.

3) The individual bond investor can safely ignore the lowest returning bonds in favour of lower-rated, but still financially stable (BBB investment-grade rated or above) corporations. Using a discount brokerage can reduce management fees to approximately 0.01 – 0.05% of your assets each year. It's simply not possible or worth your time to get high quality investments for less in any marketplace. The net result is a total higher yield for the DIY investor who chooses to ignore bond funds and engage in the often difficult and obscure task of building a rock-solid bond portfolio

Wednesday, September 30, 2009

Why are investors still sitting in cash- relevant to interest rate trends?

During this period I've been holding more GIC's than usual, as I waited out a market collapse and restructuring.

During this same period, a great deal of investors, who suffered horrible losses due to poor investment strategy, exposure to margin calls and other various gambles; have been shifting money out of losing asset classes (usually in the form of mutual funds or etfs) and waiting in cash for a different approach.

This has been the typical scenario I have faced along with most if not all of the retail investors in Canada. Before the credit crisis and ensuing collapse of worldwide economies, GICs were always capable of generating some amount of short term interest. In the early 1980s, guaranteed deposits with banks could issue interest over 7-10% for a 1 year investment. Why would you ever just sit in cash, no matter how liquid the form, when you could earn 10% simply by not touching it? People have all different reasons for investing, but the logic is simple.

During the worldwide meltdown of the past year, central banks lowered the rates at which they lend money to approximately 0.25%, this has had the consequence of reducing the interest on the typical savings account or 1 year GIC to the lowest point in history. These products still offer an interest rate in the range of 0.5-0.7% and you can typically negotiate a price with a financial services representative. The important fact remains, once the fees for these products (and there are always fees, hidden or not) are deducted from the annual yield, you are left with a return of approximately 0%. You are being paid absolutely nothing to simply wish to preserve your cash.

The mainstream media is reporting that a great deal of investors are sitting in cash because those who have switched out of one investment or asset class always place the money in cash. Investment advisors and DIY investors rarely ever have any idea when and where to invest money. "Rules" of investing, typically apply only when you are reinvesting into a product, usually an interest payment, mutual fund or DRIP with common equity in which you reinvest whatever growth occurs in dividends or your savings at regular intervals. There is a much larger problem when you are forced to have your principal returned (like with a bond), you suffer such terrible losses or you are forced to liquidate your holdings (like with funds and stocks that offer poor long term returns and margin calls).

So here is the relevant fact to consider if you are being told you have missed a rally and are tempted to throw large wads of cash at the stock market: when economies experience deflation, which is what investors are witnessing at this time, interest rates are so low that a 0% return on a portion of a portfolio of investments is still technically a positive return. The logic is simple, if the purchasing power of your money does not decrease over a one-year or two-year period, you will not lose any money and have not missed any opportunities to make greater earnings in the future.

Investors chase poor investments because they feel pressure to earn returns on their investments that are equal or superior to the market, underperformance equates to the destruction of your wealth from this perspective. However, intelligent and informed fixed-income investors never fret over missed opportunities in market rallies. The nature of a laddered portfolio requires long-term discipline to evaluate macroeconomic fluctuations (ie. Interest rate trends) in order to locate where they likely are in any given economic cycle. This equates to having money on hand to always pick a valuable investment that will grow above any foreseeable inflation rate and preserves capital.

The unusual thing about this meltdown is that it has created a synergy of intention among panicked and savvy investors. The frightened are scared to do anything with their money because everything they have done so far has at best provided no long-term returns (at worst bankruptcy and foreclosure), however because of the scale of the meltdown, interest rates of tumbled so low, and banks allowed to get away with so much, that even the wealthy and conservative are given pause as to where to find the best medium and long term value.

In a situation of global deflation, there may be asset class rallies like we've seen in oil and the stock market, but it doesn't mean the value of your money has been diminished, there are just as many if not more long-term gains to be made so long as you have the patience to find them.

Thursday, September 24, 2009

7 months later...

Well, it's been about a year since credit markets were frozen.

Last year at around this time, the economy, bond market and stock market went into a dramatic freefall. After a brief rally, the so called 'bottom' of the decline in major stock markets was reached in March.

Throughout this time, the Canadian corporate bond market has been robust and bountiful to the interested and savvy investor.

The nay sayers, who would not alter course and abandon the common perception of bonds vs. Stocks and asset mixing as I've suggested here on this blog have experienced a whirlwind.

Imagine losing half of your portfolio in 6 months and regaining half of your losses over the next 6 months.

You would now be left with 75% from the peak of your net worth. After the rebound, a large amount of investors who follow the common asset mixes are looking at their portfolios and realizing, over the long term, a total return of approximately 0%. This means they have made up all of their losses but have experienced no long term return on all of their savings.

They are still on thin ice and are simply praying that the current market rally (which suffered a one day loss today in Toronto of about 2%) continues on an aggregate pace of 7-10% growth a year from this point till the end of Barack Obama's second term.

No one seems to have learned that they could have been guaranteeing that return at a minimum for the next ten years if they had focused on the corporate debt market in Canada through this past 12 months.

So what specifically has happened in the Canadian bond market that you haven't been hearing about in the mainstream press?

1) investment grade corporate bonds, which dropped to their lowest value in march, along with the stock market, have increased in average prices, from the bottom in march, (and dropped in average percentage yield of interest payments) by approximately 50%. This is already the largest one-time rally in the Canadian corporate debt market's history. It's still not as exciting as technology stocks, or the 100% return some Canadian Financial common stock investors have seen, but tech stocks rarely pay dividends and bonds offer a guarantee and security over and above any shareholder. Investment grade corporate bonds have also been paying interest rate coupons at comparable yields to common bank stocks in Canada.

2) Throughout the entire financial crisis, companies which came to the large financial institutions in Canada and asked to borrow money in the form of corporate debt (senior debt instruments, convertible bonds, callable bonds and to a certain extent preferred shares) were consistently able to secure large financing from every major bank. What this means is that every bank had enough spare money lying around to give it to a corporation that wanted to issue bonds (anywhere from $75 million to $3 billion). The banks, having received the bonds and the right to the interest payments in exchange for all that money would create a secondary market, where the large institutional investors had first bids on everything and the retail bond desks would be stocked with the remains which are divided amongst the different brokerage houses. Throughout this process the banks are able to extract commissions and fees, further lining their already government secured pockets. This is how the corporate debt market functions in Canada (and typically throughout the capitalist world) and it is important to note that throughout the entire financial crisis it continued to function in much the same way it always does.

3) The devil is in the details. You have to follow the news and be in contact with a competent financial advisor to truly understand the current situation we find ourselves in now and the situation described above leading up to the present time. Even if the bond market in Canada was able to withstand a sell-off and rebound sharply without freezing overnight, like in the US and throughout the world, it's important to know why the bond market was selling off and what the likely consequences were for all asset classes. You need to be able to act on your knowledge of interest rate trends if you want to get good quality bonds at a discounted price or attractive yields from undervalued companies.

4) i) If corporate bonds sell off dramatically (this is what happened in september-march): it means the investing world is deeply concerned about the future profitability of entire sectors of the economy, yields will rise- a good time to buy (especially if you don't want to put money into the stock market, you'll get guaranteed stock market sized returns (7%+) for 5-10 years. Ps. The people who are worried are not investors, they are speculators.

ii) If corporate bonds stage a dramatic rally, like they have from March until the present time: it brings companies into the marketplace which would have otherwise been intimidated by all the speculation to pay back extra capital in a time of recession. Essentially, companies have been looking at the actions of central bankers to provide financial institutions with emergency money and ultra cheap loans (sometimes financed by the printing of money in the case of at least the US and the UK) and have gained confidence that they will be able to make all the necessary interest payments and have enough money to repay or refinance the principal. The Canadian bond market is a prime example of this virtuous circle playing itself out. Now endangered companies like Air Canada and the airline rewards company Aeroplan have been able to come to the big banks of Canada (in coordination with other financial institutions), and ask for loans knowing the banks still have money to keep financing their operations through the recession. A good time to buy safe investments that offer higher interest payments than government bonds.

iii) While the stock market has provided the ultimate thrill of a lifetime for someone who bought and held a portfolio of common stocks in March or early April, for someone who had the misfortune to invest at anytime in the last ten year period, they are still at approx. 0% total return, despite the wild ride since March.

Where will corporate debt (and the stock market) move? If history is any indication (which it is often not) then the economy may very well resume a period of robust growth and the stock markets of the West may continue to rise. Debt markets will likely offer similar and slowly diminishing yields in Canada during the initial periods of recovery. Unfortunately, this could also mean that all the extra money that was created actually makes its way into the economy. Basically the cost of everything starts rising because there are simply too many corporations with too much money bidding up the price of their business inputs which leads to higher costs for the consumer. The federal bankers of the world are often quoted as saying that they have learned from the past and know now when to remove money from the economy (meaning they raise interest rates on government loans and bonds and end loan programs) They are now often being criticized for being too focused on inflation, when they have been ignoring asset bubbles, but that isn't the main point. The main point is that past experience has showed government stimulus to create growth but to also create inflation, which destroys wealth. We are essentially forced to take Ben Bernanke and Mark Carney at their word each time they talk about the economy and the intentions of their respective institutions.

So if we listen to what they say it's simple:

The economy has bottomed; there is some small growth in GDP expected in the future based on the current economic situation. There is still a great deal of printed money and government spending floating throughout the financial systems and trickling down into the general economy. The economy would likely not be growing and might still be experiencing a decline of unknown severity without government spending. The good news is that for the time being, the government spending has acted in the fashion that it was intended (to create movement of capital and stabilize businesses through debt instruments). This will likely bring renewed earnings, private investment and spending which will grow the economy with the hope of creating employment.

The difficulty lies in the removal of government spending. Too soon and credit markets could suffer- actually a good time to buy investment grade bonds again. Although it could mean ongoing unemployment, prolonged recession and another big downturn in the stock market. Too late removing money and raising interest rates and we wind up right where we were last year: unsustainable asset bubbles propped up by artificially low interest rates that suffer a bi-polar, calamitous and destructive collapse requiring radical intervention- a great time to buy, after the collapse.

I've never seen a central banker in the modern era that even remotely resembled Goldilocks to me. But we, as the citizens and investors of this world, are left with no choice but to hope they get it right.

You expose yourself unnecessarily to the risk of another decade of 0% or worse if you ignore the bond market.

Sunday, August 2, 2009

interesting veiw from the PIMCO bond desk- keep learning about interest rate trends

take a look at this article


interesting to see what an insider, who performed very well this past year, what they expect from central banks moving forward.

As a Canadian bond market investor, we are possibly in for the same situation- mark carney will leave the benchmark rates largely unchanged, and there will be little economic forces acting to persuade him to change that.

what would it mean for our economy? well, previous economic history has shown that when the trend of interest rates to remain at rock bottom levels, for the yield curve to look very steep (meaning it's extremely easy to borrow short term money, and more expensive for long-term money)
In this sort of situation, banks will earn a great deal of profit. Why? because they are capable of borrowing capital from the government overnight, for about 0% interest and lending it to households and businesses for anywhere from 3-6%. This means by doing nothing they can earn a 5% return on a loaned asset. This has been called liquidity injections, monetary easing, whatever.

What it really is is allowing banks to borrow money for free. In this situation, the little guy who puts his money in his savings account will earn next to no interest. GICs will generate next to nothing. people will be more incentivized to either invest their money in physical assets which they feel will return higher than a bank account (buy a house, start a business, etc.) or they will want to put it in the stock market.

This situation is what people in the media these days are calling "the first signs of recovery", "is the recession over?"

and by all practical measures, it looks like we did avoid a total disaster... for the time being. Economies are just like ecosystems, they are resilient and yet exist in an extremely delicate balance. The stock market is booming, the housing market is bottoming and unemployment is slowing it's rise- not as many business are seeing unsustainable losses. In essense, the actions of the central banks of the world are working as they should.

In the Great Depression, the actions taken by the central banks of the world, including the raising of interest rates, had the exact opposite effect that they were originally intending their actions to have. When catastrophe was amplified by poor decision making, the public was further panicked and a negative, self-reinforcing spiral downward was continued for years on end.

In the current era, our leaders seem to have learned from the errors of the predessors and we are seeing the positive consequence of stabilizing initiative and aid.

So... coast is clear, right? recovery is on it's way? DOW 14000 by 2010? celebrate good times, c'mon?

If that were true, that we have restored a clear path to growth and that the stock market is on it's way back to the old highs, the central banks of the world would already have increased the benchmark interest rates.

The central bankers would see that the banks were making billions of dollars of of imaginary money that the government lent them, and they would see that business were making money from consumers who were willing to spend. This would have the consequence of triggering inflation- money would be moving around at a faster and faster pace- more and more deals means more and more profits, means more and more loans means higher and higher valuations for the underlying assets which are acting as collateral for loans
it seems like it's a positive, and self-reinforcing trend that makes everyone richer- which it is.
but the problem is the speed at which it happens. Some inflation means growth is occuring somewhere in the economy. But when money flies around for free, like it is now, and people spend it like it's free, which it is, all those seemingly positive things happen too fast and regular, little people can't earn enough money to keep up with the rising costs. Bingo, inflation is a big, big problem

So, if the current authorities have proven themselves capable of handling serious problems with the ability to learn from the mistakes of the past, why are they continuing this policy of free money?

look at what the guy from PIMCO is saying. If they raise interest rates now, it could recripple the financial institutions of the world, and we were just in that situtaion. The underlying economy is still fragile, it needs all the help it can get.

in this situation, inflation is still a possibility, but it's a possibility we still have to work to achieve.

Tuesday, July 28, 2009

understanding interest rate trends: contrarian history

who knew that the recent economic super-bubble was built on a empire of easy money?
a small number of people who can now claim 20/20 hindsight.
how did they make their observations?
who are they anyway?

After doing a lot of research (reading books, the news and talking to experienced investors) I came to see that the people who understood what interest rate trends say about the overall economy were the ones who were predicting an impending calamity.

Hardly anyone got the timing of when catastrophe would break out in the financial markets and spread into the real economy. In fact, the few people who did move out of the stock market right before the crash were usually just lucky to have cashed out at the right moment.

But all of these people, who understand interest rate trends, were relatively protected from losing great sums of money in the crash, largely because before the economic crisis they were considered highly conservative investors.

At one point, some people do make large bets on the stock market and perform well. But overall, their personal savings (and their recommendations for the average Canadian retail investor) were always conservative.

Why were they conservative if they were experienced and educated with respect to interest rates and finance in general?

because they understand that falling interest rates are generally related to easy money. If it's easy for corporations to borrow and for banks to lend, this generally inflates the economy and inflates the value of the stock market.

So why be highly conservative?
Because if you do the extra homework required to understand international trade and debt you would have seen all along, how deeper and deeper into debt the entire western world was becoming- excessive and increasing debt is never sustainable.
you would have therefore focused on protecting the majority of your capital by ensuring it is repaid to you in full and that you are earning an amount of interest that is safely above the current inflation rate (a spread of 5%- or 500 basis points- from the rate of inflation to the amount of interest paid is generally considered an optimum return for investment grade bonds).
you would have (if you were so inclined) still put some money in play in the stock market, to enjoy the upside, but also perhaps taken a greater risk because the majority of your money is guaranteed to be repaid- this could be more profitable or much less- depending on your choices.

My point is that I follow the wisdom of those who enjoyed success and longevity of their successes. I maybe don't understand the lessons when they're first taught. Who among us has ever been told we need to understand interest rate trends, and immediately forgotten to make it our top priority?

it is certain, with respect to understanding interest rate trends, that you will educate yourself and see the world in a different way once you do.

Monday, July 27, 2009

ladder your portfolio- a.k.a. bondage gear

We are likely witnessing a historic period in modern history.

Historic with respect to the movement of interest rates, inflation, exchange rates, employment, GDP growth, quality of life.

The key to outperforming market averages for the fixed-income investor comes down to preparation, discipline and execution.

preparation: this should be the easiest step

- plan 10 years into the future (this is the extreme long run, and should be the most flexible, least certain expectations)

- plan 5 years into the future (without the ability to plan and save with 100% certainty for at least 5 years you will not be able to meet or exceed the average market rates of return)

- once you have determined how much money you will be able to save and invest over the next five years (minimum), begin following the news related to interest rates, inflation and GDP

discipline: this requires the most concentration, understanding and synthesizing of information

- if you are living in a period of rising interest rates, it is to your advantage to avoid longer term and lower yielding bonds (you will not have sufficient cash on hand and will miss the chance to buy new issues at higher average rates)

- if you are living in a period of falling interest rates, it is to your advantage to buy and hold attractive medium to long term bonds ( you will already be outperforming new issues of similar duration),

i.e. if you buy a 5 year bond interest 6% and interest rates fall for 24 months (which they have in the past) , a newly issued 3 year bond may only yield 2.8%, buy you will already have a bond of similar duration (5 years minus 24 months) that pays more than double the new issue. even worse, new 5 year issues will yield only 4.5% interest

- credit ratings matter, you don't' need everything to be AAA, in fact you don't really need to be afraid of having nothing higher than AA (any provincial bond is rated AA).

-if you stick with AAA investments, you will be receiving the lowest yield for 'the most safety', but provinces in Canada will not go bankrupt either, fyi.

- you must avoid a high concentration of BBB, bbb issues and diversify among AA, A, BBB

execution: the most difficult step

- without an effective financial advisor, it is extremely difficult to be confident, informed, decisive, or savvy. An effective financial advisor confirms all of your expectations for how much money it is possible to safely earn, while occasionally exceeding those expectations to improve the quality of your life

- following through on the rules of creating a diversified ladder requires intuition and fact analysis eg. many thought that interest rates would never go lower than they were after 9/11. not only have they never returned to those levels, they have reached a point of essentially absolute zero- the central banks of the western world simply can't lower the interest rates any further. the point is, the investor needs to understand the way defeciet and debt affect the economy and what effect interest rates have on a debt situation (this is basic macro and micro economics)

-only through repeated experience or testing can an individual develop a savvy ability to understand the relationship between interest rates and the type of individual bond purchases they ought to make ( this doesn't mean you need to be a pro, but you will have to actually do homework to understand the nature of interest rate trends, and it's not the easiest, most entertaining topic)