Competition on the mortgage front

I notice that a certain local credit union is advertising a 5-year fixed mortgage rate at 3.45%, which is a very low rate considering it is about 125bps above government benchmark bond rates. Since the overnight rate is now 1%, they will not be making much margin on the transaction. This also implies they have confidence in the price stability of the local real estate market, and being in the Greater Vancouver area, makes you wonder whether this is a valid assumption.

Something that is not easily discovered is their loan criteria – for example, if getting such a rate required a 40% down payment, then the rate might be warranted since the bank would have recourse and recovery in the event of a mortgage default.

Looking at the variable rate market, the best rate I can find is 0.85% below prime (prime is currently 3.00%), but if other institutions are over-capitalized, this discount to prime will continue to increase as they compete for loans. It makes you wonder whether consumer demand for debt has slowed down.

If you put a gun to my head and forced me to choose a mortgage that would result in the lowest interest paid over a 5 year term, I would still go for the variable rate. However, that said, 5-year mortgage rates cannot go much lower than 3.45% – maybe down to 3%, but that’s about it before you really question the sanity of financial institutions offering loans at that rate.

There is some risk of short term rates rising even further in 2011 and 2012, but it doesn’t seem like such movement would be extreme if it did occur. For financial modeling purposes, the market is saying that the 2011 increase will be 0.43%. There are scenarios where this rate could skyrocket, and also scenarios where the short term rate goes back to 0.25% again (where sitting on a prime minus 0.85% mortgage is really inexpensive!).

Relative debt pricing – Yield and Quality

Noticed that AON Corporation (NYSE: AON), which is a financially stable and large insurance broker, issued some debt to fund a $1.5 billion dollar takeover of another corporation:

Of these notes, $600 million will mature on September 30, 2015 and bear interest at a fixed annual rate of 3.50 percent; $600 million will mature on September 30, 2020 and bear interest at a fixed annual rate of 5.00 percent; and $300 million will mature on September 30, 2040 and bear interest at a fixed annual rate of 6.25 percent. The offering is expected to close on September 10, 2010.

They have a convenient 5-year, 10-year and 30-year maturity, which compared to the US treasury bond is a spread of 2.05%, 2.35% and 2.52%, respectively compared to the closing quotes in September 8, 2010. AON is receiving very cheap debt financing, and the bonds were rated BBB+, although one can see by a quick look at AON’s financial statements that despite the takeover (which is roughly a $5 billion purchase, half cash, half stock that dilutes shareholders by about 20%) they should still be generating sufficient cash to pay off the debt.

So let’s pretend you are owning some 30-year corporate debt in a less solvent entity (e.g. QWest) and have a yield to maturity of 7.5% on a similar bond. Do you trade 1.25% of yield in exchange for higher credit quality? Or do you think the macro environment (e.g. the risk-free rate) will turn hostile to long bond yields and both assets will depreciate? Very difficult to say.

Bonds are trading high

When markets move in a direction, the trend typically goes longer than most people otherwise anticipate. The Vancouver Real Estate market is a great example, or I could just be completely wrong and not realize there is some fundamental underpinnings that I am unaware of.

I believe this lasting momentum is the case for the bond market – today, I continue to unload at a pace of a trickle some of my slightly-better-than-junk debt (long-dated maturities) because the quotations just keep going higher.

Fortunately, some of it is sheltered in a registered account so I can defer the tax hit for a future time, but some of it is in the non-registered account. There is a tax timing problem in that I ideally would want to carry forward gains into the 2011 tax year, but it is better to take the bird in hand, rather than waiting 4 months. The taxes have to be paid eventually, but I’d rather want to pay them in April 2012 than April 2011.

Chances are in four months the bond party will still be going strong (especially when people dump their annual RSP contributions into the hottest bond fund they can find), but as a bond investor, I am getting very concerned as to the macro movement toward fixed income products and accordingly am continuing to leak my positions to the market as quotations go higher.

My cash balance continues to rise in the portfolio. It is at a higher level (in absolute but not percent terms) than at the end of 2008!

Talking finances and social relationships

The best finance writer on the internet today, in my opinion, is David Merkel. Everything he writes is absolute wisdom that he has accumulated over his experiences and career as an insurance firm asset manager.

His last post on the typical “What should I do?” question that a lot of people (who don’t devote nearly as much time to the marketplace) give is something that I’ve had to deal with quite often.

The true issue is that whenever you start to mix together money and social relationships together, you end up with the potential for lots of trouble. This is why I never wade into the issue of finances in conversations unless if the other side explicitly brings it up and is clearly seeking my opinion on a matter. A few of my friends and colleagues know I write prolifically over the internet, but most do not.

My usual line of conversation, after being asked “the question” (What do I do with my lump sum of accumulated savings that I haven’t earmarked for my mortgage that is collecting dust in the bank account) is me asking a question back, “When do you need the money, and can you suffer, say a 20% loss and still be ‘okay’ about it?”

The typical answer I receive is, “I don’t know. Maybe two years? But I would still like to see the money there, while it would not kill me to lose 20% of it, I still would not like that to happen!”

Whenever I hear this, if this was my money with a similar risk profile, I’d probably spread it around some relatively safe convertible debentures that are due to mature in a couple years. Doing a cursory scan of the Canadian market you have about a 5% yield to maturity on decent 2-year term corporate issues out there, and going up to about 7% depending on what your definition of “relatively safe” is.

On Merkel’s post, he states:

I say to my friends asking advice, “Remember, I am your friend. I will take no money, but I won’t hold your hand and guide you either. I will give you very basic advice, and it is up to you to learn and implement it.” I don’t want to be a financial planner, but I don’t want to leave friends in a lurch.

Recommending debentures to others requires them to do quite a bit of homework (at a very minimum, fishing for prospectuses on SEDAR). It also requires them to deal with financial instruments that are quite unlike what they have previously been exposed to (at most, buying and selling common shares). There is little chance of this (them researching prospectuses, getting a ballpark valuation and doing the transaction) happening. Not helping either is that with most brokerage firms in Canada, they charge an arm and a leg to trade debentures.

So as a result, instead what I end up saying is, “Get a 2-year GIC. I believe [a CDIC-insured financial entity] has a 2-year GIC going on at a rate of 2.4%, which is a good market rate compared to other institutions. Even if you go to [big known Canadian bank], you can get about 2% which is not bad either.”

The usual response back, “But Sacha, 2.0-2.4% is NOTHING! Can’t I get a higher return on my money?”.

Then I just say, “Yes, you can probably get more, but this means taking more risk, and means taking a lot more time to follow and know the market you are talking about getting into. At least with the GIC, your money will be there for another day, and if you get more comfortable with investing, you can use that money. It is better earning zero return on your money than a negative return. If you really, really want to gamble, take 10% of your money and put it in a brokerage account where you can trade around and likely lose it – you can consider this as a form of tuition.”

By this point their eyes glaze over, they say thank you, and then the conversation goes to something else. After a few months, you usually end up discovering they invested the money in some sort of “balanced” mutual fund that charges a 2.5% management expense ratio and posted good 2-year past performance numbers strictly due to the fact that everything has gone up between then and now, especially in the fixed income world. You know that they will lose money in the future, but there is nothing you could or should do other than just smile and move on to a different topic.

Bank of Canada raises rates 0.25%

As I was speculating, the Bank of Canada has raised interest rates by 0.25%, which is a change from 0.75% to 1.00%.

The key guiding paragraph to determine future rate hikes is in the last paragraph. From the July 20 statement:

Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.

From the September 8 statement:

Any further reduction in monetary policy stimulus would need to be carefully considered in light of the unusual uncertainty surrounding the outlook.

The phraseology of changing “would have to be weighed” with “would need to be carefully considered” suggests that the Bank of Canada is not necessarily totally done raising rates, but it is not out of the question if data warrants so.

The next Bank of Canada scheduled announcement is October 19, 2010 and the last one for the year is December 7, 2010.

3-month Bankers’ Acceptance Futures are at 1.24% for September and 1.3% for December. Both are trading about 0.15% up from yesterday as a reaction of today’s news. The futures imply there is roughly a 20% chance of a rate increase between now and years’ end.