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.

Rogers Sugar, aftermath

Since Roger Sugar announced its fiscal Q1-2010 results in the middle of February 2’s trading day, the stock has been on a relative free-fall:

The current price of $4.40 is skimming the bottom of my fair value range for the units and it will be interesting to see if it slides below that.

Normal volume for the units are about 140,000 a day, so it is clear that there is some institution or fund that is trying to unload their units. They are not getting much liquidity in the market, which is why the price takes a dive. Opportunistic investors love to wait for moments like these to add to their positions, although it is difficult to game whether the institution or fund dumping units have half a million, or five million units to sell. If the entity dumping units is interested in selling more, they will be pressing the market further.

I would venture that a disproportionate amount of holders of Rogers Sugar are people that will be holding for a very long time, simply because the units do provide a good flow-through entity for investment capital – at a $4.40 unit price, there is a 10.5% yield and even better yet, the yield is sustainable with true earnings.

I also do not think the announcement of the fund considering a distribution cut because of the income trust taxation due 2011 is new news – all profitable income trusts will be doing the same. From my own investment perspective, it will mean shifting units out of my RSP and into my taxable accounts since eligible dividend income is taxed much more favorably than interest income that comes from the trust.

Rogers Sugar reports quarterly result

My largest holding, Rogers Sugar Income Fund, reported a solid but not spectacular quarter. What was odd is that they released the result at 1:30pm eastern time, which was mid-day while the market was open. The market hardly blinked and then a couple hours later there was some minor volume at slightly lower prices to end the day.

The debentures (which I do not own) are trading at around 105% of par value both with a yield to maturity of less than 4%; they do not mature until June 2012 [$50M/6.0%/$5.30/unit conversion] and 2013 [$85M/5.9%/$5.10/unit conversion]. They can be called away at par in June 2010 and 2011, respectively, which is possible if they can secure cheaper financing. The debentures could even be converted to equity if the units trade above the conversion price, which is another possibility. Either way, at present, the solvency of the trust is not in question – they have very good access to credit.

I absolutely love the external reporting style of management – they do a very good job walking you through the GAAP numbers, which are contaminated with inflated and deflated numbers as a result of management’s rigorous hedging of input costs. Management then gives you metrics which separate the timing effects of the hedging. They do it in such a way that is simple, yet elegant, and this is presumably a reflection of CFO Daniel LaFrance‘s style. It is also a textbook example of why GAAP is not the be-all-and-end-all of financial reporting – this will equally be true with the implementation of IFRS (International Financial Reporting Standards), another scheme mainly to enrich accounting consultants and make financial statements even more unreadable than they are presently.

The sugar industry is something that I never quite intended on being relatively knowledgeable about, but over the past few years I’ve accumulated quite a bit of information of the industry, at least of how it applies to Canada. The industry is fairly easy to research, which makes the evaluation of management’s ability to keep costs down and be able to make educate guesses on where the marginal risks are critical, which I think Rogers Sugar has done a good job doing.

Rogers Sugar Income Fund (through Rogers Sugar in Western Canada and Lantic in Central Canada) services mostly the domestic Canadian sugar market – there is one significant competitor in Central Canada (Toronto) in Redpath Sugar and there are also fringe competitors such as Sweet Source Packaging in Toronto, which is under the label of Sweet Source Sugar. The domestic market demand for sugar has been very slowly dropping over the past decade, presumably due to industrial usage shifting toward sugar knock-offs (such as high fructose corn syrup and artificial sweeteners), but otherwise is relatively stable. Despite what one sees at Superstore and Costco, the vast majority of consumption is through industrial usage (such as most of the stuff you would see at Tim Hortons).

Because most countries heavily subsidize their sugar industries, there is a high degree of protection in the industry. As a result, Rogers Sugar, Lantic, and Redpath are able to compete primarily on domestic fronts. There is some small volume of competition that will be coming through Costa Rica through the free trade agreement implemented with them, but it should have a small impact on the domestic marketplace. In addition, the USA and Mexico occasionally open up some component of their own domestic marketplace whenever they face domestic sugar shortages – such as when an adversely located hurricane decides to wipe out their production capability.

Most of the input costs come from importing raw sugarcane from locations south of the USA and processing it into granulated sugar products. In Taber, Alberta, Rogers Sugar additionally harvests and processes sugar beets into raw sugar. The primary cost (other than labour) of refining this raw product comes from the energy consumption required to transform the product – which is through natural gas.

A positive change in price of refined sugar will have a positive impact on gross margins for Rogers Sugar, at the expense of cannibalizing some of the marketplace for substitutable sugar products as those suppliers will convert to high-fructose corn syrup. As sugar prices have been at record highs lately, it remains to be seen whether the positive impact on gross margins will be more or less offset by the reduction in sales volume.

Rogers Sugar gives off a distribution of $0.46/unit (9.75% on the current unit price of $4.72), and this quarter is the first time that management has announced that they are looking into alternative structures with respect to the onset of income trust distribution taxation in Canada. Specifically, they have stated:

We are investigating corporate structures as an alternate to our current income trust structure. Whether we convert to a corporation and as a result pay corporate income taxes or continue with our income trust structure beyond 2010 and become subject to distribution tax, we currently anticipate paying dividends or distributions at levels that would provide an after tax distribution equivalent to that currently enjoyed by our Canadian taxable Unitholders.

This statement implies that their distribution will be reduced to approximately 32 to 33 cents per unit (6.89%). This is a few pennies lower than what I was expecting (mainly 0.46/(1+26.5%) = 0.36 in 2011; 0.46/(1+25.0%) = 0.37 in 2012) but we will see. The company has been doing a good job keeping distributions lower then their free cash flow and have applied the retained earnings into a reduction in leverage – something I find to be a wise decision that will facilitate a much easier refinancing of the debentures.

Merits of the GIC-only investment strategy

I was reading an article on the Globe and Mail about David Trahair, who advocates a GIC-only investment strategy.

Despite the relatively negative income tax implications (the income from the GICs are fully taxable unless if sheltered in an RSP or TFSA), it is not a bad strategy because it can be implemented with a few clicks of the mouse and should provide protection of principal in most situations. It is something even the most unsophisticated investor can perform and you can shop around for the best GIC rates by using a site like GICBroker.com as a guideline for where to get the highest rates.

The only relevant risk worth mentioning is that you are exposing yourself to is inflationary risk (loss of purchasing power of principal), but given the relatively low duration of investment (an average of roughly 3, assuming you are using a GIC ladder) should properly capture heightened interest rate expectations if and when CPI inflation does occur. Right now the best 5-year GIC is a good 100 basis points higher than the equivalent Government of Canada 5-year benchmark bond rate (2.47% vs. 3.5%).

The other comment is that James Hymas makes a very good argument for preferred shares in a portfolio that will diversify the risks associated with having a GIC-only portfolio, and makes for a very good read. Implementing such a change in a portfolio does involve quite a bit of financial sophistication for the do-it-at-home investor, however.

First Uranium will be an interestnig story

Ever since the environmental permit for their tailings mine got revoked by the South African government, First Uranium equity has traded lower. Their debentures have also traded from roughly 75 cents to 71 cents.

Today, however, they will likely trade lower because of First Uranium’s corporate update. In it contains the following words:

The announcement of the withdrawal of the EA has not only delayed construction of the TSF, it has also disrupted certain well-advanced corporate financing opportunities, which, along with the slower than expected production buildup at the Ezulwini Mine, would, if alternative financing is not obtained, severely compromise the Company’s financial position. The Company is now reviewing strategic alternatives, and is engaged in discussions with respect to alternative financing opportunities.

My guess is that the common stock will trade down about 10% on Tuesday and the debentures will trade down another 3 cents. The company will likely have to sell more equity in future gold sales (as they have done previously), or equity in their company in a heavily dilutive offering. Management does not own too much common stock and is likely to dilute through equity to reduce the influence of Simmer and Jack.

The latest financial update from First Uranium was at September 30, 2009. The debentures are CAD$150M and they would be first in line (after a $22M facility) in the event of a default.

The valuation of First Uranium, as its operational woes continue, have to increasingly be looked with respect to what the asset value of operations would capture in the event of a bankruptcy proceeding. As long as the price of gold does not crash, there is value in the operations and debenture holders will likely be able to still make a fair recovery.

Most of the value of the debentures, assuming they are paid, will be in the form of capital gains so keeping these outside the RRSP is likely the best option – at 65 cents on the dollar, your split will be 1 part income to 3 parts capital gains, assuming they mature. Any resulting income will be taxed at around 62% of the income produced from the investment.