TFSAs to increase?

One of the campaign trail promises was to double TFSA contribution limits to $10,000/year if/when the budget is balanced.

Given the existing projections of the federal government, this may not happen for a few years, if ever.

However, an increase in TFSA contribution limits would make them much more significant vehicles for investing than present. It is a much more functional solution than giving some form of relief on capital gains taxes – effectively the TFSA becomes the conduit for this, or for relieving people from paying taxes on interest income.

Because of the contribution limit rate, TFSAs disproportionately favour lower net worth individuals – for example, if your net worth was $20,000, you could invest it all tax-free but if your net worth was $1,000,000 then it would be a drop in the bucket. It is a surprisingly egalitarian method to allowing tax-free compounding of capital.

The only negative part of the TFSA is that you can’t write off capital losses – so make those choices carefully.

Learning to read statements faster than others

First Uranium posted a production report for their last quarter. In the Thursday morning very long release contained the words that all equity investors dread:

The Company’s current cash resources may be insufficient to address its medium-term working capital needs. Accordingly, the Company has retained RBC Capital Markets as its financial advisor to review all funding alternatives.

Nobody appeared to read this paragraph until the opening of trading on Friday when presumably all the analysts released negative reports on the company.

The company’s common stock declined significantly Friday – from about $1.17/share to about $1.05/share presently. What is interesting is that this is purely from the news contained in the Thursday release – so institutional investors and analysts could not interpret the statement until given an evening to doing so.

I sold all the debentures (TSX: FIU.DB) out of my TFSA on Thursday for 80 cents on the dollar, but this was strongly instigated by the report. Most people on Thursday mis-interpreted the report as “steady as she goes” for the company operationally when they likely missed the critical part concerning the future capital requirements.

I also had some debentures in my non-registered account that I jettisoned, but still have some position.

First Uranium will likely have to raise further equity or debt capital to bridge their capital expenditure requirements. After that, presumably their existing Ezulwini mining operation could be cash flow positive. The equity is a high risk, high reward situation that I have not invested in. Depending on how such financing is structured it could be positive for debenture holders (e.g. a straight equity raise), but the company is otherwise restricted in terms of raising secured debt because of an existing agreement with noteholders (of which I own some as well).

TFSA Update

A brief history of my TFSA: My strategy is to invest the TFSA in high risk-to-reward candidates that ideally will generate income that would justify its positioning in the TFSA for tax sheltering. My goal is a rapid compounding of capital with high risk/reward candidates. The TFSA will not be diversified as it is part of an overall portfolio, hence the lack of diversification.

In 2009, $5,000 was deposited into the TFSA. The first investing was invested in debentures of Harvest Energy Trust on February 2009, which was bought out by KNOC in October 2009. I cashed out the debentures and the account was left with a balance of $13,043 at year-end. Result: A 161% gain for the year. This is obviously unsustainable year-to-year.

In 2010, $5,000 was deposited into the TFSA. On January 2010, I invested the proceeds of the TFSA into debentures of First Uranium Corporation, which turned out to be a badly timed entry (if I had waited a week later I would have received a price 10% less than what I paid for due to bad news that was released literally a day after I had made the purchase) and the setback tested my investment acumen. The fundamental reason why I had invested had not changed, so I kept the debentures. In October 2010, I swapped half the debentures for (secured, convertible at a relatively low equity price) notes in the same company which has turned out so far to be a good decision. Result: The TFSA ended 2010 at $20,486, which after adjusting for the $5,000 deposit, is a return of 13.5%. Given the risk, however, I would judge this as a poor performance.

The two-year annualized performance (adjusting for deposits) of the TFSA was 72%. Again, this number will not likely be repeated in the future for 3, 4 and 5 year periods – this number will be going lower.

In 2011, after transferring in $5,000 into the TFSA at the beginning of the year, there is approximately CAD$5,500 sitting in the account that is currently languishing. I have been researching investment candidates and while I could deposit the proceeds into a relatively low risk investment that would yield around 6-7%, this is below my return threshold. The TFSA is still sensitive to the performance of First Uranium debentures and notes which should provide some element of growth in the portfolio (should be around 15%), but the rest of the cash needs to be deployed otherwise it will drag performance. I do not wish to invest in any more First Uranium at existing prices.

I do not want to invest cash for the sake of investing cash, so I will be patient and continue looking for opportunities. Such a bland strategy of holding zero-yield cash is boring and does not make for good writing, but it is disciplined.

Trading credit principal for quality – TFSA update

As readers here may remember, my TFSA investment (which I am trying to compound as quickly as possible) was in First Uranium debentures (TSX: FIU.DB), unsecured senior debt, coupon 4.25%, maturing June 2012.

This has been one of my lesser performing investments, due to a horrible entry point (the company announced some adverse news shortly after my investment), which I had an opportunity to see the writing on the wall and liquidate (which I could have received a very acceptable price), but unfortunately my worst decision in the year was to not.

Anyhow, my TFSA is currently sitting about $600 below the end of December 2009 mark (netting out the $5,000 deposit), which is not too good since my other (fixed income) investment candidates at the time would have resulted in an actual increase on investment, which is the whole point of the TFSA. If I was planning on losing money, I would have prefered to do it in the RRSP or in the non-registered account so I could deduct the loss. C’est la vie – that’s how things work sometimes. The question is now, how to get back on track?

The first thing to look at is whether the underlying securities are still worth keeping based on new information that has been received in the interim. First Uranium went through a recapitalization which saw common shareholders be diluted in the form of a convertible notes offering (senior, secured by all assets minus what Gold Wheaton is entitled to, maturing March 31, 2013, convertible at $1.30/share, 7% coupon, TSX:FIU.NT) and a 14 million share settlement to Gold Wheaton (TSX: GLW) since FIU did not finish constructing a mine module in time. The company itself remains active in the gold mining industry (despite the company’s name, Uranium is a small part of the business), having two mines operating – Mine Waste Solutions (which is operating well and is profitable) and Ezulwini (which has been a basket case operationally and has been losing money). After firing most of the board and management, it appears there are hints that the company is coming back to financial life again, especially with gold prices at the high prices they are at today.

The company’s financials, once they stop spending big cash on capital expenditures, should be cash generating and healthily profitable even if you believe they will moderately underperform the economic projections in the technical reports. So it becomes a matter of whether the market believes the management can deliver operationally, and whether the management is credible. Given the history of the company, they are not and the common stock and debentures trade as if this is the case.

Thus, this is a high risk, high reward scenario. I have only gone superficially into one of the risks in this post, but there are other risks that I have mentally dissected.

While I do not think this investment is a slam dunk, when you adjust it for risk/return, there is a compelling investment thesis on the debt of First Uranium, and possibly the equity, which appears to be somewhat undervalued. There is a huge amount of default risk for the equity holders, and some risk for the unsecured debenture holders, and limited risk for the secured note holders.

The TFSA transaction that I recently performed was to sell half the debentures ($12k face) at 70 cents on the dollar, and then use the proceeds to purchase $10k face of notes, which I subsequently purchased at 88.5 cents on the dollar.

Why would I trade lower priced unsecured notes, maturing earlier (and a better annual compounded yield at existing trading prices) for more expensive, secure notes with a later maturity and less yield? The quick answer is that I am trading yield for quality.

The longer answer is that I am reasonably confident that the secured note holders would be able to receive the full principal amount in a bankruptcy liquidation of First Uranium. There is $150M outstanding and the company is likely to fetch more than this from Mine Waste Solutions alone. The upside for the noteholders (beyond a payout at maturity) is the $1.30 strike price, 2.5 year call option embedded in the notes, which provides a mild amount of equity participation without actually having to own the equity. The equity is currently about 67% out of the money as of this writing.

If FIU does get its act together, it is likely that the equity will increase higher than 67%. However, the equity is far too risky in the TFSA – it is better suited to a non-registered account where you can at least book capital losses if it tanks.

Finally, there is the scenario of what happens to the unsecured debenture holders when their maturity hits (June 2012) – the company will either likely make an offer to extend the maturity or give the debenture holders a sweeter deal (higher coupon and lower conversion rate) while the company tries to make its mining operations profitable. I do not think the unsecured debenture holders will force the company into bankruptcy simply because of their rank – they have relatively less negotiating power.

I will emphasize that equity in First Uranium is a highly risky investment, and the debentures are a risky investment, but the notes appear to be less risky, and are priced to represent the lower risk.

The notes are also better positioned in the TFSA (since you will likely see your money back), while debentures are better positioned in the RRSP (income is tax-deferred, but you can still benefit if you have a loss of prinicpal), and equity is positioned in the non-registered account.

RRSP Loans never made sense

I have now received three unsolicited solicitations (two through postal mail, one through email) for pre-approving me for an RRSP loan. The rates both institutions were offering were 3%, up to a low 5-digit dollar amount. The terms of such loans are such that you have to pay it off in a year.

The advertising always tries to grab your attention by stating that by loaning money you can get a good fraction of it back from the government when you file your income taxes and some people probably use this to rationalize making a loan. Unfortunately, the true financial value of the tax credit is worthless. I won’t get into why in this post, but some fellow wrote about it here and it is a much better way of thinking about one’s RSP than what is otherwise intuitive – his reasoning is not intuitive, but it is correct.

I have always wondered why anybody would ever bother doing an RSP loan from a rational perspective and the scenario that comes into mind deals with a high-income individual that has their cash flows so lumpy that they will only receive it after the March 1, 2010 contribution deadline and where this person’s balance sheet is in such crummy (or illiquid) shape that they cannot pull out non-taxable reserves into the RRSP umbrella. It would also imply their cash management in prior years is equally crummy since they failed to save enough money to pay for the RRSP.

Such people are likely to have high levels of debt, which highly suggests they should be putting their cash into their debt. However, in the event that their debt has a low interest rate, then the RRSP loan would make sense.

In other words, the number of people that truly need RRSP loans are next to none. I can’t fabricate a real life scenario where somebody working a full-time job would want to loan money for an RRSP.

Ever since the advent of the TFSA, the retirement savings game has changed considerably – although there are exceptions to every rule, if I had to make a “one rule fits all” criteria for RRSP vs. TFSA contributions, the math highly suggests the only people that should ever be considering to make a contribution in an RRSP are those making more than (note: 2010 year) $81,941 a year, which is where the 26% federal tax bracket kicks in. Otherwise you should contribute money to your TFSA first, and then your RRSP with any leftover amounts you have left to save.

If you make less than $81,941 a year, your first dollars should go to your TFSA and then if you have money left to save, into your RRSP. In no way should your net taxable income go below $40,970 – you can still contribute to your RRSP, but you should wait until a future year where you make more than the lowest bracket to actually deduct the income.

Taking out an RRSP loan to defer the income tax is financially foolish, especially since the interest on the loan is not tax-deductible. The only exception I would make is if you are supremely confident you will be able to make more than the loan interest on an after-tax basis (so let’s say you are in the 40% tax bracket and your RRSP loan is at 3% interest; you would need to make 3%/(1-0.4) = 5%) but I do not think this is appropriate for most and that taking an RRSP loan is functionally equivalent to borrowing money in a brokerage account to invest. The only difference between an RRSP loan and borrowing to invest on margin is that at least when you borrow to invest on margin, you can deduct interest expenses from your income tax.

Next TFSA investment – First Uranium

Following the success of getting out of Harvest Energy debentures, I had a lot of cash in my TFSA, especially after the January 2010 contribution of $5,000. There was only one debenture candidate left on my radar that appeared to have a good risk/reward characteristic. Although it wasn’t great, it was good enough and I executed a trade on it.

Continuing with my less than diversified strategy, I have placed the sum of the TFSA into the debentures of First Uranium (FIU.DB). The debentures give a 4.25% coupon, maturing in June 2012. They are convertible into equity at $16.42/share, but this is unlikely to be a factor in the valuation. The total issue was for CAD$150M. They went as low as 41 cents in the debenture crash of early 2009.

The price I received was 74.5 cents on January 11, which is a 5.7% current yield and an implied annualized capital gain of 13.0%. Assuming a 1.2% (short term interest rate) reinvestment of coupon, this is a realized return of about 16.8%, which is (barely) above my investment threshold. The previous Harvest Energy investment was above 30% at the time and price I made it, but the spring of 2009 was a very special investment climate where buying anything would give you massive returns. Today, things are much different and you really have to pull out a high powered microscope since anything with a high return has a lot of baggage you have to sift through. First Uranium is no exception.

First Uranium is a Toronto corporation, but with operations primarily in a South African mine with uranium and gold reserves. The name is misleading in that the bulk (~85%) of the company’s revenues are expected to be from gold sales. The foreign nature of their operations introduces a risk, but South African mining operations have been able to operate sustainably in other circumstances. Although I have my geopolitical concerns about South Africa in the medium term (10 years out), I have discounted such concerns in the 2.4 year timeframe of this present investment. It is also likely that coming closer to maturity that the investment may be liquidated sooner than later, or when the yield shrinks to my sell target (around 95 cents presently).

Most of the operations have been financed by equity – the last financing was done in June 1, 2009 at CAD$7/share. Today the common shares are at $2.66/share with 167M shares outstanding – a market capitalization of about $444M. Some portion of the gold reserves have been hedged off at below-market rates for up-front financing. In addition, the mining operations are still at the end of the initial capital injection phase before they can start producing sustainable positive cash flow, which is expected in the March 2010 to March 2011 fiscal year.

In terms of management and ownership risk, this is an interesting story. Simmer and Jack, another (larger than junior) South African mining company, owns 37% of the company as of September 2009. There has been a recent management and board struggle dealing with the Simmer and Jack management, who have moved over to First Uranium after they were kicked out of the Simmer and Jack board. The kicked-out CEO and Chairman, Gordon Miller, owns 1.66% of Simmer and Jack and roughly 0.1% of First Uranium. Although this struggle has an indirect impact on the value of the debentures (mainly that I am concerned about being paid off rather than owning the company), it is worthy to note that some deal must have been cut with the existing Simmer and Jack board such that he be allowed to run First Uranium since the 37% minority ownership of Simmer and Jack would likely be able to prevent him from doing so if they did so voluntarily.

There is a complex relationship here with respect to the debentures – Simmer and Jack is highly incentivized to make sure the debenture holders don’t take over the company so they can realize value of their equity stake. Gordon Miller likely wants to make a ton of money out of the deal and try to get some sort of revenge against Simmer and Jack and try to wrestle control away from the company. Either way, the debentures will have to be paid and it seems likely at this point it will be done by a simple equity swap – the current market capitalization is sufficient to pay off the debentures with about 25% dilution to existing shareholders.

On the balance sheet, First Uranium has US$60M in cash at the end of September and they have poured in about US$563M into their mining operations. Their only significant liabilities are a $22M loan from Simmer and Jack, and the CAD$150 of debentures. The income side is ugly when one looks back, but the corporation should start to generate cash through mining operations in the upcoming year and slow down capital expenditures – and perhaps even pay some common share dividends sometime in the second half of 2011 if things really go well and the refinancing of the debentures are in the bag.

The risks otherwise are typical of a mining firm – commodity pricing (gold and uranium) and realization of “proven” reserves into actual output. There is also some currency risk – they report in US dollars and their equity and debentures are denominated in Canadian dollars. Reading the technical report on the main mine and getting a feel for the operation is also essential (and rather dry) reading.

Although this investment is not the most ideal, I do believe that the company will be able to pay off the debentures, whether by refinancing, equitizing the debt or generating cash flow before the June 2012 maturity. There is enough of a margin of error to feel comfortable, but not “home free”, which is why the market value is trading significantly below at present. Assuming their story turns out, the equity side is also a compelling story, but it contains a high degree of risk that I am not willing to take – especially concerning the future of gold prices. That said, I expect these debentures will be made whole and will be a positive decision in terms of my risk-reward profile and being able to avoid income tax and capital gains tax by virtue of it being in the TFSA.

I also prefer short duration plays simply because when interest rates rise again, cash might be a more attractive option.

(Subsequent note: Operational risks include adverse news releases after hitting the “publish” button, although I do not think this one is too severe to my underlying investment thesis.)

ING Direct trying to trap capital in TFSA accounts

I noticed at the start of the year that ING Direct was offering a 3% 90-day GIC for RRSP accounts (no transfers required) and also 3% for a TFSA account, but with the rate subject to change at any time.

Anybody with an RRSP in ING Direct would do well to lock in the 90-day rate as soon as they can; even though they stated they will offer it until March 1st, they could revoke it. The difference between a 3% rate and a 1.25% rate (which is more representative of the current market rate for a 1-year GIC) is $43.15 on a $10,000 investment. It is not huge money, but it is more money nonetheless.

The 3% TFSA offer is quite a lure, but it is designed to trap as much money before they reset the rate back to a lower rate. The trick with the TFSA is that once customers have deposited their money into the TFSA, it is a lot of unnecessary paperwork to get their money out of the TFSA account once the rate resets to something lower. If customers decide to withdrawal the TFSA once the rate goes lower, then they lose the contribution room into their TFSA until January 1, 2011.

For those people that want to keep their money in a risk-free instrument (e.g. a GIC), use the ING Direct TFSA at your own peril. As a matter of financial planning, the TFSA should not be used as a risk-free account anyhow, but some people will want to use it to park idle cash.

ING Direct used to be the undisupted best place to save money, but over the past few years they have become just “normal”. They are still excellent with respect to having a no-fee operation and this works to their benefit – if money is easy to get out of them, then I feel much safer keeping money with them. For matters such as RRSP and TFSA transfers, however, there is a real bureaucratic cost associated with these and it is not worth it to capture an extra 0.5% elsewhere for the dollar amounts in question that people typically deal with.

If ING Direct wanted to raise a lot of longer duration capital, they’d do fairly well if they offered a 5% 5-year GIC.

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.