Wednesday, May 13, 2009

Interest rate trends and GICs

So I talk a lot about fixed-income investing and usually like to focus on investment-grade corp. Bonds.

But when I look at my investment portfolio and the changes that have taken place over the past few years, I think it's important to comment about interest rates.

Following the 'benchmark' bonds, issued by the federal government, that are used for bank to bank lending; following the medium and long-term 'benchmark' government bonds; and following the popular GIC rates is critical in becoming educated in the Canadian bond market.

If you visit this is an excellent resource for tracking US government issued debt.


Look at the "yield curve", this graph plots the various maturities according to their current market yield.


Two important facts:

  1. The volume of bonds (government and corporate) that are exchanged on a day to day basis is roughly 10x greater than the value of the volume of cash exchanging hands via the stock markets of the world
  2. Because there are so many different types of issues and different maturities of bonds from each individual issuer, it is uncertain and unlikely that individual bond issues will be traded every day. This is the 'liquidity risk' people refer to when holding bonds, when interest rates (or the price of your bond) fluctuate and they hope to sell their bonds in order to capitalize, only to find that selling their bonds is difficult.

Because of these two facts, it's possible to think of the bond market as a kind of ocean cruise-liner (please refrain from Titanic analogies), which parallels the vitality of the overall economy. When investors the world over have confidence in the economy, the government or bonds in general, it typically drives up the price of all bonds and when the government is encouraging growth, it typically lowers interest rates to encourage lending and ultimately lead consumers to avoid putting their money into savings. Governments can be like the captain, ordering to speed up or slow down the ship- lower interest rates typically encourages growth, higher interest rates encourage saving money and taking it out of the economy to curb inflation.

In the previously described situation, the world before the economic meltdown was fairly reflective of my description. After the meltdown, a flight to safety and the lowering of benchmark rates for intra-bank lending has created the perfect storm. Captain Bernanke has ordered all men to the coal furnaces; fire the engines, full steam ahead! Benchmark interest rates of all maturities have plummeted to the lowest point in history.

This is important for me, because when I moved my money into fixed income, I temporarily placed a lot of it in GICs. The strategy is simple: Most advisors recommend, and a common misconception is, that it's to your advantage to be fully invested at all times.

Conversely, the way the corporate bond market works, it's actually best to buy in increments (part of the reason laddering your portfolio so that 10% of your portfolio value is freed up each year for reinvestment). So as I moved out of equities and income trusts and into the fixed income market, 1 year GICs- cashable after 30s days without penalty- are an ideal holding point for my investments if I'm not sure what to be looking for right away.

Due to giving my attention to my own search for alternative investments and the way things worked out with the economic meltdown, I've ended up holding onto the majority of my GICs, I started holding cash at 3% and the last time I purchased any (in September of 2008) the yield was about 1.4%. Now that the Federal Reserve systems around the world have gone to work, the yield for a similar GIC is now literally 0%. It's getting close to the point where you have to pay for a GIC to hold your money....

This is a problem for me as the GICs will be due in September. Fortunately, I believe the credit markets have not collapsed and this has turned into the greatest time to purchase corporate bonds in recent history.

The moral of the story is what I will call the DNAGS dynamic multi-sector wealth factor.

DNAGS stands for DO NOTHING AND GO SLOWLY. The secret of wealthy people who have managed to preserve and grow their wealth is their staying power. Sure, it's important to be confident, aggressive and pursue opportunities as they arise. What is equally important is staying conservative and using a conservative philosophy to avoid being overly-committed or jumping in too early into an investment before verifying it's soundness (this has the consequence of typically looking for moderate total average yield- with the bonus of enhanced security and confidence in your investments).

So as it is, I have about 4 months until my last GIC is due, month by month, I've been moving out of GICs (starting with those which yield about 1-1.4%) and into corporate and some provincial bonds.

So far, I've been able to take money that was earning about 1% and turn it into investment-grade bonds (no maturity longer than 6 years, so far) that are yielding about 6%

This is at least a full percentage point (or 100 basis points) better than the corporate bond ETFs available in Canada. I paid my advisor an average one-time commission of 1% of the purchase price.

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