Present cost of portfolio insurance

I am noticing that the implied volatility of the S&P 100 is below 20% right now, which is the lowest it has been since when the financial crisis really picked up steam (September 2008). At the peak of the economic crisis this was around 80%.

The concept of portfolio insurance is simple – buying put options represents a form of insurance. You can play with these options and come up with some concepts that can be translated into English for less financially sophisticated people.

Let’s pretend you owned $100 of the S&P 500. If you wanted to insure your portfolio against any further downside for the rest of 2010 (i.e. you wanted to guarantee that you could sell your $100 of S&P 500 for $100 at the end of 2010), how much would it cost you? The answer is about $9.89 given closing option prices on December 24, 2009. This sort of insurance is good if you anticipate a possibility of the market declining, but you still want some “skin in the game” in the event the S&P 500 goes up between now and the end of the year.

We can repeat the same thought experiment, except asking ourselves if we wanted the right to sell your $100 of S&P500 for $90 by the end of 2010, a 10% loss. This insurance will cost you $6.14 to purchase.

The difference between these two values are $3.75.

What this practically means is you can bet the following ways (again, note I am indexing the value of the S&P 500 right now to 100 for the purposes of this post):

1. You can bet that the S&P 500 will not drop at the end of 2010. Reward for getting this right: $9.89 for $100 notional risk. Punishment for getting it wrong: $9.89 minus $1 for every $1 that the S&P goes below $100 at the end of 2010.

2. You can bet that the S&P 500 will not drop more than 10% at the end of 2010. Reward for getting this right: $6.14 for $100 notional risk. Punishment for getting it wrong: $1 for every $1 that the S&P goes below $90 at the end of 2010.

The “bets” to describe the results of predicting an S&P 500 level of 90 to 100 are a little more complicated to explain, but they can be done with portfolio insurance as well. Essentially you can feed any probability distribution into a model and have it crank out the optimal purchases/sales of options to correspond with your crystal ball forecasting.

Since I can’t forecast indexes, I’ll leave this to the gamblers. That’s what most option markets end up being. Right now, the option markets are saying that they expect volatility to be low, which keeps option prices low. This generally favours people that have strong beliefs that the markets will go rapidly in one direction or another.

Canadian government firing a warning shot on real estate

Finance Minister Jim Flaherty made a statement on December 18, 2009 regarding maximum amortization periods and down payment rates. While I don’t have a copy of the statement or speech made, the National Post has a fairly good summary.

The salient detail is that the finance ministry might change the guidelines and decrease the maximum amortization period of a mortgage (currently 35 years), and increase the minimum downpayment (currently 5%). It would be likely that 30 year mortgages with 10% down payments will be the new rule.

The federal government is probably realizing that the CMHC has guaranteed a ton of debt and in the event of a Canadian real estate meltdown that it would have to pay a very heavy bill as people begin to default on underwater mortgages – this would occur when incomes do not rise to match rising interest rates. Most of the Canadian banks would get away with the financial damage, while CMHC would be paying the bill.

CMHC does collect a one-time insurance premium, according to this schedule:

Loan-to-Value Premium on Total Loan Premium on Increase to Loan Amount for Portability and Refinance
Standard Premium Self-Employed without third Party Income Validation Standard Premium Self-Employed without third Party Income Validation
Up to and including 65% 0.50% 0.80% 0.50% 1.50%
Up to and including 75% 0.65% 1.00% 2.25% 2.60%
Up to and including 80% 1.00% 1.64% 2.75% 3.85%
Up to and including 85% 1.75% 2.90% 3.50% 5.50%
Up to and including 90% 2.00% 4.75% 4.25% 7.00%
Up to and including 95% 2.75% 6.00% 4.25%* *
90.01% to 95% —
Non-Traditional Down Payment
2.90% N/A * N/A
Extended Amortization Surcharges
Greater than 25 years, up to and including 30 years: 0.20%
Greater than 30 years, up to and including 35 years: 0.40%

So let’s pretend you buy some Yaletown condominium for $400,000 and decide to pay 5% down and a 35-year amortization.  Your insurance premium, with a verifiable income, is 3.15%, or about $12,000 for the right to have your bank protected in the event of you defaulting on the $380,000 mortgage.

If the rules change to 10% down and 30-year amortization, the CMHC premium goes down to 2.2%, or about $7,900 on a $360,000 mortgage.  Strictly looking at the premiums, it would suggest that changing to a 10%/30-year system would reduce defaults by 30%.

The problem deals with correlation – if one mortgage defaults, it is more likely that others will in a cascading line (mainly because CMHC will have to sell the property in order to recover as much of the defaulted loan as possible, depressing the market, and likely causing other strategic defaults).  It doesn’t matter what caused the default, but my prime hypothesis is when people go and get their 2% floating rate mortgages, when the Bank of Canada starts to raise rates in the middle of 2010, people will be facing double interest payments when they haven’t properly budgeted for it.

There is also the batch of people that got low 5-year fixed rate mortgages facing renewal – right now 5-year fixed rates are still at relatively low rates (3.8%) but the party will end.

The finance ministry is just trying to make sure the party ends slowly (by people paying off their high-leverage loans over a long period of time), instead of the cops coming in and storming the house (if people can’t pay the interest on their high-leverage loans and cause a cascading default).  Jim Flaherty probably knows this is a financial time bomb that can potentially go off if the wrong circumstances hits the economy, and is taking preventative medicine to do so.

CMHC mortgage bonds currently trade like fixed income government securities.  You can see a chart of mortgage bonds outstanding on this chart.

Should you take CPP at age 60?

Canadians that have been employed and contributed to the Canada Pension Plan currently have an option whether to take their pension at age 60, or wait until later before they start drawing benefits.

The general rule is that if you worked 35 of 42 years of your working career (i.e. from age 18 to 60 minus 7 low income years) at a full level of CPP contributions (in 2009 this implied a $46,200 salary) you will receive approximately $11,210 per year at age 65 as your CPP pension.

If you decide to take CPP when you hit the age of 60, you will be penalized 0.5% per month, or a 30% total sum; this will reduce your annual take-home to $7,847 per year. The advantage is that you get to collect $7,847 a year for five years, while in the scenario of taking CPP at age 65, you would receive nothing until reaching that age.

If you wait until you reach age 61, your penalty goes from 30% to 24% and this is not a 6% increase in benefits; it is actually (0.3-0.24/0.7) or a 8.57% difference.

Most commentators on this issue do a “breakeven age” analysis of CPP. While this is mathematically correct, even if your life expectancy is expected to be longer than 76.7 years (which is the breakeven age between taking CPP at age 60 vs. 65), there are two very relevant factors to take into consideration:

1. The guaranteed income supplement (GIS). If you have no other expected income at the age of 65, you will effectively be taxed on CPP income at the rate of 50% because for every dollar of CPP you earn, you will have your GIS reduced by 50 cents.

2. If you take CPP, if you ever work again, you no longer have to pay CPP, which is a 4.95% savings on your paycheque.

3. A dollar earned at age 60 is more useful than a dollar earned at age 65 simply because of the probability of dying goes higher and because money is easier to spend while (relatively) younger. This “quality of life” factor is almost never discussed.

The only reason one would want to delay taking CPP beyond the age of 60 is because they are expecting to make enough other supplemental income where the GIS clawback no longer becomes a factor and also that they have enough bottled income stashed away (i.e. through RRSPs) that they are in no need of money at the present moment. In this case, the expected lifespan of the individual becomes the primary determinant of when to take CPP.

All of this discussion does not discuss the rule changes that will be taking place for people taking CPP in 2012 and beyond. I have analyzed this previously. The rule changes will discourage people from taking CPP early.

Harvest Energy debenture liquidation

I noticed in my accounts today that the “D” series of Harvest Energy (6.4% coupon, maturity October 31, 2012) has been sold at 1.015 on the dollar. I set the order about a month after the takeover announcement.

At this price, the debentures have a current yield of 6.31% and an implied capital gain of -0.51%.

There is a floor price of 1.01 on the dollar because of the obligation of KNOC to purchase all debentures at this price; my sense of risk suggests that I should be liquidating them on the open market higher than the 1.01 repurchase price. I don’t want to wait two and three-quarters years to collect my money since I can probably reinvest the proceeds at a rate better than 5.8%.

The “E” series of trust units is a little trickier; its coupon is 7.25%, maturity on September 30, 2013. Right now it is at 1.0175 which is implying a current yield of 7.13% and a capital gain of -0.46%. It is priced relatively lower than the D series. If you assume the same yield valuation on the E series, you get a price of 1.045 on the debentures (current yield 6.94%, capital gain -1.15%) but the debentures will never trade that high. My liquidation point for the E series is between 1.015 and 1.045 and we will see if it gets there.

Harvest “G” is the longest duration and highest coupon (7.5%, maturity May 31, 2015) and it is trading at 1.026 currently. This is an implied current yield of 7.31% and a capital gain of -0.67%.

I will be happy to receive a premium over the 1.01 floor price and be rid myself of the debentures, preferably in the new tax year. I don’t like liquidating gains at the end of a tax year, but the price offered was too attractive. Fortunately, this liquidation also included my TFSA, which is now sitting at $13,000 for the end of this year.

I am also relatively pleased I can liquidate these things for a premium on the open market, mainly because if I had to submit instructions to my broker (in this case, Questrade), I have a sinking feeling that they would screw up the tendering or otherwise cause me to lose liquidity.

Harvest Energy takeover finalized

Harvest Energy has finalized their takeover with KNOC, so their units will be delisted as follows, per the press release:

As a result of the acquisition the Harvest trust units will be delisted from both the Toronto Stock Exchange (“TSX”) and the New York Stock Exchange (“NYSE”). The NYSE has advised that the trust units will cease trading on that exchange on or about December 23, 2009 and the TSX has advised that the trust units will cease trading on or about December 29, 2009.

This is an interesting delisting schedule, mainly because if you own the Canadian version of the units, you have a tax election. If you are sitting on unrealized losses, you want to liquidate the shares immediately so that way you can claim the capital losses on your 2009 tax return. If you are sitting on capital gains, you can defer capital gains taxes to your 2010 tax year by selling the units on December 28, 2009.

(Update: I had failed to account for the fact that December 28, 2009 was a statutory holiday in Canada and the exchanges were closed this day, but the trust units were still traded on December 29, 2009, which means the election above was still available.)

Canadian tax rules about year-end selling – Trade date vs. Settlement Date

(Update on the text below: IT-133 has been removed from the CRA’s website. Please read the December 31, 2012 article for further information.)

When you purchase or sell shares on a stock exchange, the current date is called the trade date. However, the actual transaction (the exchange of shares and cash) is processed in three business days, which is known as the settlement date. So for example, if you bought shares of something on Tuesday, December 8, the transaction is settled on Friday, December 11.

Computer networks and electronic processing of share transfers have made the three day requirement antiquated, but nobody has bothered to amend the rules.

One practical consequence of the three day settlement rule is determining which year a transaction was processed with respect to capital gains taxes. Take the practical example of selling shares for a $100 capital loss on December 30, 2009, with a settlement date of January 5, 2010. Do you report your $100 capital loss in your 2009 or 2010 tax filing?

The answer is 2010. Most financial publications out there correctly advise people that they have to dispose of their shares by December 24, 2009 in order to be able to book a capital loss (or gain) in the 2009 year. The trade will settle on December 31, 2009. A trade made on December 28, 2009 will settle on January 4, 2010. The reason is because both Christmas Day and Boxing Day are considered to be non-business days in Canada.

Most financial publications do not quote the source of the rules which governs this issue, mainly CRA Interpretation Bulletin IT-133. The rules using the settlement date was codified in this bulletin in 1973, which has survived to this very day.

As a final note, the USA uses a different system. For people filing with the IRS, they consider the trade date to be the year of disposition. The USA exchanges do not use Boxing Day as a non-business day, so trades performed on December 28, 2009 will settle on December 31, 2009.

The best stock pick for the past 10 years

It is always interesting to pour over historical data and ask yourself how you could have figured this out had you not had the benefit of hindsight. Everybody calls this “the next Microsoft”, but these days, they are not turning out to be revolutionary software companies.

The largest gainer in the past 10 years turned out to be Green Mountain Coffee Roasters. Back in the beginning of the year 2000, they were $0.88/share, split adjusted. Today they are $69 a share. So $1,000 invested in this company back in the beginning of year 2000 would have resulted in a cool $78,400 today.

What does Green Mountain Coffee do? While their business at the beginning of the century used to deal with selling coffee, they made an acquisition of Keurig in 2006 which turned out to be a major value-added acquisition on their part. The rights to the Keurig coffee machine, and selling the K-Cup packs has been incredibly profitable. It is a razor and blades business model, where the coffee machines take K-Cup packs. Each K-Cup is good for a serving, and typically costs about 50-100 cents to purchase for each serving.

The trick is getting as many of the machines in the public, and then collect royalties on K-Cup sales. They appear to have done that.

My only experience with the K-Cup was in the Air Canada Lounge in LAX airport. They had a K-Cup machine and it made coffee, but I wouldn’t have sold my soul for it. The fact that the machine also creates a lot of disposable junk turns me off somewhat. But somehow GMCR has managed to get enough of its razors into the marketplace, and has enough consumer adoption that they are making huge money off the blades.

In terms of the stock price, I think it is safe to say that we won’t be seeing another 78 times appreciation over the next 10 years, but it will be interesting to see whether GMCR can grow its business to the level that the stock price suggests.

How could have one seen this 10 years ago? Nearly impossible. Even 3 years ago when they took over Keurig, instinctively I would have thought “Who in their right mind would pay 60 cents a pop for their own home coffee machine when you can just as easily grind your own beans?” I’m guessing that cost wasn’t the factor, rather convenience of having to not deal with the messy parts of good coffee making. If I thought that the coffee it produced was vastly superior to the traditional methods, then perhaps I thought the company would have a chance. But I guess convenience trumps cost in this case.

Bank of Canada getting nervous about debt levels

The Governor of the Bank of Canada in a recent speech is saying that while the economy appears to be recovering, that household debt levels are of a concern. Most consumer debt expense is through a mortgage.

In particular, the following paragraph is worthy of mention:

The simulation generates a scenario indicating that, by the middle of 2012, almost one in ten (9.6 per cent) Canadian households would have a debt-service ratio greater than 40 per cent, the threshold above which households are considered financially vulnerable (Table 2). Moreover, the percentage of debt owed by these vulnerable households would almost double. Both of these metrics are well above their recent peaks.

It is worthy to note that “Scenario 1” and “Scenario 2” of the Bank of Canada have short term interest rates at 1.5% at the end of 2010, and 3.1% at the end of 2011 (in Scenario 1) and 4.00% at the end of 2011 (in Scenario 2). These are hypothetical scenarios, but it does not appear that the Bank of Canada will be keeping rates at 0.25% past their June 2010 declaration.

A debt service ratio is generally considered to be debt interest expense divided by pre-tax income. Depending on what type of statistics one prefers to look at, household income in Canada averages roughly $86,000 for a married couple, or roughly $36,000 for an “unattached individual”. In the case of an individual, a debt coverage ratio of 40% is paying approximately $14,400 a year in interest payments, or about 1,200 a month.

Right this second, the best market rate you can get on a variable rate mortgage is prime minus 0.25%. Prime currently is 2.25%. So if you have your average unattached individual buy a condominium for $300,000, they will be paying about $6,000/year in interest payments. However, if the bank rate goes up 2.85% as it will in “Scenario 1”, suddenly that $6,000 interest payment will be going to $15,300 a year. On a $36,000 pre-tax income (or about $29,300 take-home given BC 2010 tax rates), this is a huge amount of debt service, just over half. If you use a $50,000 pre-tax income, your net take-home goes to $38,900 and interest represents 39% of after-tax income.

Harvest Energy Trust takeover by KNOC approved

The takeover of Harvest Energy Trust, for $10/unit and acquisition of debt by the Korean National Oil Company (KNOC), has been approved by Harvest Energy unitholders. The vote was 90.2% in favour. They required 66.7% for approval.

One particular note of amusement is the Harvest Energy Yahoo message board that was dominated by trolls were screaming about voting against the merger. If you believed that the message board was a representative sample of the unitholders, you would have received the impression that the takeover vote would have failed 90% against, instead of in favour! Message boards for most companies are worse than useless – the information that travels through them should be regarded with the same credibility of that of supermarket tabloids.

Retail investors generally do not matter in terms of corporate governance – it is the institutional investors, primarily mutual, pension and hedge fund owners that control most of the votes in publicly held corporations. The market had priced in Harvest units as if the takeover vote was a done deal, and indeed, the market was correct on this projection.

Once the takeover is finally cleared, with an expected date of December 22, 2009, Harvest will be delisted. My guess why they do this at the end of the year, opposed to the beginning of January is because so many people have accrued losses on Harvest Units that management decided it was worth crystallizing the capital losses for the 2009 tax filing, rather than deferring capital gains for 2010.

Within 30 days of the takeover, KNOC is obligated to make an offer to the debenture holders for the cash repurchase of debt at 101% of par value; I will be tendering my debt (or selling it on the open market above 101%, whatever the case may be) simply because of uncertainty of being able to be paid out. While I have glossed over KNOC’s financials, and believe them to be a very solvent and viable corporate entity, the information I have on them is not timely, they do not report to SEC or SEDAR, and I don’t want to have to deal with a Dubai-like situation where Harvest Energy defaults on its debentures, and KNOC will not guarantee the debt.

I am quite happy to tender the debt in 2010 as this way I can defer capital gains until I file my taxes in April 2011.

TFSA account transfers

If you are considering changing where your TFSA account is, it is probably easier to liquidate around this time of year (mid December) and withdrawal all the funds from your account and deposit the cash to a new account early in January of the next year. Assuming you have $5,100 in a TFSA account on December 15, 2009, if you withdraw it before the end of the year, your TFSA contribution room on January 1, 2010 will be $10,100 ($5,100 plus $5,000) and you can open up an account wherever you want and deposit it. In fact, you can open up an account and just fund it exactly at the beginning of the year.

If you withdraw the $5,100 on January 1, 2010, you will have to wait until January 1, 2011 in order to be able to bring the $5,100 of capital into the TFSA tax shield.

The true value of the TFSA won’t be felt until years later when everybody will have contribution rooms sufficiently high that you will be able to shield considerable amounts of savings – assuming interest rates ever rise to respectable levels again (e.g. 5%), in 10 years, you will be able to shield $50,000 at 5% interest, or about $2,500 of tax-free income a year. This essentially will create a risk-free situation for most ordinary people to shield interest income from the government.

The TFSA is truly a financial instrument of lower-income Canadians, while the RRSP is the preferred vehicle for higher-class Canadians. Unlike the USA Roth IRA, the Canadian TFSA is a heck of a lot more flexible – you do not have to wait until you are 59.5 years old to withdraw funds without tax penalty.