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.