IGNORE BOND FUNDS

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

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.

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.

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

take a look at this article

http://www.bloomberg.com/apps/news?pid=20601087&sid=aPZx5kGyDavA

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.

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.

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)

I'm in Asia! learning stuff!

granted there are lots of cost saving ways to travel in south east asia.

the downside? you have to travel for at least 24 hours and fly literally to the other side of the planet.

as well, depending on where you go, no one will understand english.

I'm in the philippines because it still is an undeveloped tourist destination: it's even cheaper than thailand or vietnam and many of the beaches and resorts are pristine.

the best part: everyone one here loves Americans (they don't distinguish between white people from north america) and everyone (even those with little or no education) can understand rudimentary english.

It's very easy to get around and no one will over-hustle you: they simply aren't used to a tourism industry like thailand or vietnam (depending on which city and region you choose).

So what am i doing here? well, i mentioned previously that i spend a lot of time looking for alternative investments since i left the world of traditional asset mixing. Just so happens that i have a personal connection with a fellow who is highly connectd with the asian development bank, head quartered in manila.

did i ask for a specific deal, strategy or investment opportunity? NO.
what i did is called networking. I took the effort and time to find this person and to simply have a conversation. In essence, it was a global cold call.

We talked at length about my personal background and i had the opportunity to seek his opinion on much of the global turmoil taking place. His views on what counts as stable, what counts as volatile and what counts as a bargain are all well informed and based in the real world of securing credit (from a multitude of central banks and global financial institutions) for medium to large size firms involved in import/export trade throughout all of asia.

What did i learn that i can relate to you?
a few basic opinions, with the caveat that my new friend admits even the most informed cannot predict the future.

but he did point out the long, protracted nature of the current recession.
he pointed out that there is still a great deal of bad debt that has not worked its way through the global financial system (credit card debt is now just starting to become a serious problem for global financial institutions).
when asked, he pointed out that automatically, the rest of the world has been moving away from the american dollar as the international currency.
a basket of international currencies used by large, global financial institutions for transactions, referred to commonly as "special drawing rights" (SDRs) are now gradually becoming the defacto world currency.
He also noted that among international central bankers, there already exists a consensus that the world will eventually eliminate free-floating currencies and create a single world currency.
THis is a very difficult thing to accomplish and will not be realized for years, perhaps decades (if ever- no guarantees on the future)

But he was very clear, the old currencies: the pound, the american dollar, even the euro are in for a very, very bleak future. If you hold investments in these currencies, if you attempt to trade with these currencies, you will be very stressed for a long, long time. you may even lose a great deal of money.

what does it mean for the canadian bondage freak?

a declining US dollar will destroy the majority of canadian exporters. this will completely overwhelm any short-term recovery efforts and likely drive up unemployment, drive down exports and delay any significant growth in the economy.

the consequence is lower earnings across the board. your mutual funds are not coming back. you will be lucky if they remain at their current levels.

your fixed-income? keep it 7 years max. and widely diversified

why? every central bank in the world is printing money. those who ignore history are doomed to repeat it. we're in for inflation (not a guarantee, but an educated guess). if you're strictly buy and hold, you have to avoid the long-term (even if it means taking a lower total yield). if you stick with a bond mutual fund or buy something 10-year, 20-year or god forbid 30-year, you could stand to underperform the market dramatically.

don't buy stocks, unless they are a totally dominant company that is having a down period, and don't overly invest in stocks.
keep buying bonds, but remember, inflation will be higher than people might expect and you need to be able to purchase new issues at higher interest rates, because interest rates will rise. the federal governments have done as much as they can to hold rates down for the time being, but if this really is the big bad unravelling of the empire of debt the West has built, it's going to be a long, slow, painful road to recovery