Analysis of RESPs

The Registered Education Savings Plan (RESP) is a tax sheltered vehicle that is designated for parents to save up for the education of somebody – usually this is the children of the people contributing to the RESP, but in theory you can define anybody as a beneficiary of the plan. Eventually when such people take higher education, you can designate proceeds to the beneficiary in question, and the beneficiary will take the income contributions as taxable income. Presumably because they are young and have less income, they will pay little to no tax on the proceeds.

For the rest of this post, I will define the beneficiary as just “children”.

Benefits and disadvantages

The benefits can be summed up in three points:
1. Transferring income while avoiding attribution;
2. Income tax deferral;
3. Canada Education Savings Grants.

The disadvantages can be summed up as follows:
1. Risk that your children will not seek higher education.
2. Requires financial skill to self-manage.
3. Fees.

The competing choice is funding money outside the confines of an RESP and giving it to the children when they go to school, or to give some portion of money to children and having them invest it in their own names.

Analysis

To put the conclusion first, my general analysis suggests that RESPs are only useful if you intend to fund part or all of your childrens’ educations and you are very convinced they will be going to an eligible higher education institution. In other words, I would not contribute to an RESP until they are, at the latest, 15 years of age when you can detect whether they have enough ‘scholarly’ potential to warrant it and you have sufficient after-tax funds that won’t put a hole into your own personal finances.

If you discover your child does not want to attend upper education, you can move the RESP proceeds into an RRSP, but there are non-trivial conditions attached with this transferability. Otherwise accumulated income taken out the RESP is taxed at your marginal rate plus 20%.

From a financial perspective, the RESP enables you to avoid attribution by indirectly “giving income” to your children, and also shelters growth of funds from taxes (which will eventually be taken as taxable income by the children). Contributions are not tax deductible and principal withdrawals are not taxed. The excess of principal payments is taxed.

The Government of Canada will chip in some money via the Canada Education Savings Grant, which will contribute 20% of the first $5,000/year contributed, to a lifetime maximum of $36,000 contributed. So in theory if you contributed $4,500/year ($36,000 total) for the first 8 years of your child’s life, the CESG would result in an extra $7,200 in the account. If your family income is less than $77,769/year, the CESG grant will be 30% of the contribution amount. If your family income is less than $38,832/year, the CESG grant will be 40% of the contribution amount.

The CESG is a material benefit when investing in an RESP, functionally acting as an instant 20% return on investment. Using the “contribute until the last moment” strategy, the CRA helpfully points out the criteria that must exist in order the RESP to receive the CESG:

However, since the CESG has been designed to encourage long term savings for post-secondary education, there are specific contributions requirements for beneficiaries who attain 16 or 17 years of age. RESPs for beneficiaries 16 and 17 years of age can only receive CESG if at least one of the following two conditions is met:

* a minimum of $2,000 of contributions has been made to, and not withdrawn from, RESPs in respect of the beneficiary before the year in which the beneficiary attains 16 years of age; or
* a minimum of $100 of annual contributions has been made to, and not withdrawn from, RESPs in respect of the beneficiary in at least any four years before the year in which the beneficiary attains 16 years of age.

This means that you must start to save in RESPs for your child before the end of the calendar year in which the beneficiary attains 15 years of age in order to be eligible for the CESG. The CESG and accumulated earnings will be part of the educational assistance payment paid out of the RESP to the beneficiary.

Assuming your child enters into upper education when they turn 17, the safest strategy appears to be determining how much money you intent on contributing and dividing them into $5,000 amounts. If you have $5,000 to contribute, then put that into the RESP the year your child turns 15, and put it in a 2-year GIC which matures when they are ready to enter higher education. If you have $10,000 to contribute, put $5,000 into the RESP when they turn 15 (into a 2-year GIC), and another $5,000 the following year into a 1-year GIC. This way, you will realize a 20% gain plus whatever the return on the GIC is.

This strategy requires no financial sophistication other than the effort to find a fee-free RESP provider that gives good fixed income rates and taking out the appropriate GIC with the specified maturity date.

The RESP gives the contributor full liquidity capability – they can withdraw principal at any time, but they would have to refund the CESG in the process. Still, the availability of liquidity is a crucial factor in an investment decision, and having the ability to get back your principal (e.g. let’s say you lost your job when your child was 6 years old and the RESP is hardly going to be a high priority at this time compared to an education that may or may not happen in 11+ years) is very important.

I cannot find good justification for employing other investment strategies concerning RESPs – for example, if immediately after the birth of a child the parents open up an RESP for the child. In this scenario, the primary risk is that the parents will need the money at a future date and a more pressing reason than the far-off goal of purchasing educational credits for children. The other risk, of course, is not knowing whether the newborn will be attending such an institution. Also, because of the long timeline, such investments are likely to be more risky in nature, requiring a level of financial sophistication to invest in the proper stocks and bonds. Finally, the benefit of avoiding income attribution could be entirely avoided by transferring the funds to the child’s name and investing the proceeds in securities that will yield capital gains (as capital gains will be attributed to the child, while income will be attributed to the parent).

Thus, the “get the CESG as late as possible” strategy is likely the only real viable strategy for the RESP.

A final note on scholarship trusts

It is my opinion that most education scholarship trusts are terrible, terrible, terrible investment vehicles compared to the strategy presented above. In addition to paying fees that are ridiculously expensive, you are surrendering liquidity, and also surrendering the flexibility to get your money whenever you want if your child goes to school. For example, if your child decides to enroll into a two-year trades program, you will receive significantly less money than if he/she enrolled in a four year program. In particular, I will single out the largest of the scholarship trust companies, Canadian Scholarship Trust, as being financially counter-productive to any parents’ wish to actually pay for their children’s educations via an RESP. It is my opinion that companies like those are what give other educational scholarship companies an incredibly bad name.

It is true if you jump the hoops just perfectly (i.e. making your monthly payments from an early date, never missing payments and having your child continue with a 4-year education) that enrolling in such a plan would be a net plus, but the risk taken is phenomenally higher than the simple strategy presented above. The performance of the Canadian Scholarship Trust has also not been that much higher than a GIC – the 5-year performance from October 2003 to 2008 has been 4.5%. You can read this and the rest of the gory details on their prospectus document – a document that I suspect most of their subscribers don’t read, mainly because if they did so they would quickly realize what a bad deal they are receiving.

Yield chasers are going to get killed

I note that James Hymas has observed that an issue of Royal Bank preferred shares (essentially a fixed rate coupon of 6.25% that will be redeemed at par in February 2014) is trading at a yield-to-call of 2.93%. Essentially investors will be paying $28.31 to receive a cash flow of $1.5625 per year until February 24, 2014, and a payment of $25 on February 24, 2014.

Putting this another way, an investor is paying $28.31 today to receive $5.625 in preferred dividend income and taking a $3.31 capital loss in less than four years.

When you compute this at the highest marginal tax rate, it makes even less sense – trading income for future capital losses makes the proposition even worse on an after-tax basis.

The only justification I could come up with why this occurs is two-fold:

1) Unsophisticated investors do not realize that the preferred share will be called away for $25 on February 2014 and purchases the shares in the mistaken belief that their yield will be roughly 5.52% ($1.5625/$28.31 = 5.52% and this is what you would see on most typical stock quote providers as the “dividend yield”);

2) Fixed-income funds that have been swamped with investor capital just buy the preferred shares blindly without regards to any stringent valuation criteria.

Either way, when seeing action like this on the markets, it is a sign that yield chasers are paying far too much for income-oriented investments. It makes me very wary to be playing the preferred and bond markets at the moment. Individual opportunities have pretty much dried up during the last half of 2009 and the remaining issues that are trading below par all have some chronic business issues that make them less than “safe”.

My focus as of late has been on the equity side, a much more difficult world to analyze than bonds and preferreds.

Kitco selling Rhodium

I take a look once in awhile at Kitco’s precious metal store and notice they are now selling Rhodium.

Rhodium is a very interesting precious metal and it is by occurrence about four times less common than gold. Other metals of roughly similar concentration are Iridium, Ruthenium, and Rhenium – all a bit cheaper than Rhodium.

I don’t have any particular love for precious metals other than that they are nice to look at and feel (especially the density), but one big concern as an investor would be – are you actually getting what you paid for? Once you receive the Rhodium in the mail, how do you know you got shipped the precious metal instead of shreds of some other (cheaper) metal? Obviously you are relying on the reputation of Kitco (which is solid) but once you sign for the package in the mail and rip open the container, how do you verify Rhodium?

At least with gold there is a basic non-destructive test you can run at home to knock off all forgeries (water displacement). Unfortunately, the density of Gold is nearly identical that of Tungsten, so to detect Tungsten forgeries you have to resort to an interesting methods (e.g. determining how fast sound waves travel through the metal – sound moves through Gold about twice as slow as it does through Tungsten). Also, working with Tungsten is very difficult (the melting point of Tungsten is very, very high, much higher than gold).

If I ever bought a gold bar, the first thing I would do is the displacement test. It would also be rather fun to perform.

A large component of value for most precious metals is the psychological value that somebody else had to go through a lot of work to mine and refine a lot of ore to concentrate the metal into a nearly pure form. This is contrasted with industrial usage, where you can make a genuine argument with respect to the value of a metal.

For example, if somebody invented a way to repel gravity, but it had to rely on Rhodium, you can be sure that the price of Rhodium would skyrocket and it would quickly replace crude oil as being the most commonly quoted commodity in the news.

Bellatrix Exploration debentures trading lesson

I own (clarification: after today, this should be “owned”) some debentures of Bellatrix Exploration (formerly True North Energy Trust). They mature in June 2011, coupon of 7.5%. They also were a relatively safe pick to be redeemed at maturity.

Today the company announced they raised money for more debentures and announced their intention to redeem the existing debentures. The debentures have an early redemption term as follows:

Subject to closing of the Offering, Bellatrix intends to give notice on or following the closing date of the Offering of its intention to redeem its currently outstanding approximately $84.9 million 7.50% Convertible Unsecured Subordinated Debentures due June 30, 2011 (the “Existing Debentures”). The Existing Debentures are redeemable for an amount of $1,050 for each $1,000 principal amount of the Existing Debentures plus accrued unpaid interest if redeemed on or prior to June 30, 2010 or an amount of $1,025 for each $1,000 principal amount of the Existing Debentures plus accrued unpaid interest if redeemed after June 30, 2010. A determination as to the redemption date will be made prior to closing of the Offering. Proceeds from the Offering will be used by Bellatrix to partially fund the redemption of the Existing Debentures and the balance of the redemption amount is intended to be funded through bank indebtedness.

Earlier this year, Bellatrix debentures were trading very close to 102.5, which was my exit price. I was actually the asking price at one point in time, but nobody bought my asking price. I had assumed the company would wait until June 2010 to mature the debt and just left my open order at 102.5, assuming they would never consider an early redemption at 105.

I was apparently wrong – the debentures today traded from 102 to 104, settling around 103.5. The people buying above 102.5 obviously are speculating that management will be redeeming earlier than the June 30, 2010 date.

The math is pretty simple – the new convertible debenture deal closes on April 20, 2010. If the company redeems early, they will pay $2.125 million more in redemption premiums if they do it immediately after the deal closing than if they did so in June 30, 2010. If they wait the 2.3 months before redeeming, they are paying $1.22 million in interest payments, and this also does not include the company’s ability to utilize the $85 million in capital during that time period. Even if they redeem today, they will be paying $1.59M in interest expenses, much less than the $2.125 million they would save by delaying the redemption.

The calculation highly suggests the debentures will be redeemed on June 30, 2010, and anybody buying Bellatrix at 103.5 is insane. When the debentures are deemed, they will receive a -3.6% annualized return on their investment.

The trading lesson here, however, is that keeping open orders in this manner exposed myself to the risk of this happening and as a result, I am short a small amount, but an amount that certainly would have paid for quite a few ribeye steaks.

I also could have avoided this issue by actually waking up at 5:30am Pacific time and reading the press release to cancel my order, but Pacific coast investors automatically face the handicap of having the financial world set on the eastern time zone (even for an Alberta corporation) and I was obviously asleep at the time.

I am happy, however, that this trade was successful in the overall scheme of things.

Canada Interest Rate Projections – March 2010 – Effect on mortgages

With all the talk about the Bank of Canada wanting to raise rates, it is instructive to look at what the futures market is saying about the issue. It should be noted that the next scheduled rate announcements are as follows:

April 20, 2010
June 1, 2010
July 20, 2010
September 8, 2010
October 19, 2010
December 7, 2010

A rate increase on or before the July 20, 2010 meeting is a guarantee. The question is how much?

The markets currently say the following:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 AL 0.000 0.000 0.000 99.480 0.000 0
+ 10 MA 0.000 0.000 0.000 99.440 0.000 0
+ 10 JN 0.000 99.320 99.325 99.360 -0.040 21736
+ 10 SE 0.000 98.870 98.880 98.910 -0.040 33614
+ 10 DE 0.000 98.400 98.410 98.450 -0.050 19923
+ 11 MR 0.000 97.980 97.990 98.030 -0.040 6402
+ 11 JN 0.000 97.630 97.640 97.690 -0.050 3215
+ 11 SE 0.000 97.320 97.350 97.410 -0.080 1445
+ 11 DE 0.000 97.040 97.060 97.140 -0.090 707
+ 12 MR 0.000 96.810 96.840 96.910 -0.080 50

The three-month interest rate will be:

June 2010: 0.68%
September 2010: 1.13%
December 2010: 1.60%
March 2011: 2.01%
June 2011: 2.37%

Reading my tea leaves, this would suggest that the Bank of Canada will raise per the following schedule:

April 20, 2010 (No change – 0.25%)
June 1, 2010 (No change – 0.25%)
July 20, 2010 (+0.75% to 1.00%)
September 8, 2010 (+0.25% to 1.25%)
October 19, 2010 (+0.25% to 1.50%)
December 7, 2010 (+0.25% to 1.75%)

It is also likely that by June 2011 that interest rates will be around 2.5%.

The only effect these rate increases will have on mortgages are for floating rate mortgages (ING Direct offers them at prime minus 0.4%). This would mean that rates would go up from 1.85% to 3.35% by the end of the year and roughly to 4.1% by the middle of 2011. For most borrowers on floating rate mortgages, they will likely see their interest payments at least double over the course of the year. As an example, for somebody borrowing $300,000, their interest payments will increase from roughly $450/month to roughly $1000/month by the middle of 2011.

In terms of fixed rate mortgages, rates are essentially set by the bond market, and the bond market has already “baked” in these projected rate increases. The best available 5-year fixed rate mortgage is 3.69% currently. Given a choice between these two options, it is a rare time where taking the 5-year rate would be the prudent option.

It is likely once interest rates start to increase that banks will increase the “prime minus” spread from a typical 0.4% currently to around 0.8% – the peak discount which was seen in the last housing rush.

Either way, the lack of ultra-cheap credit will have an effect of slowing down the housing market considerably.