ING Direct RRSP GIC – The price of liquidity

I was looking with curiosity at ING Direct’s RRSP GIC page to get an idea of what the retail risk-free rate would be. They had the following term and rate schedule:

1 Year 1.75%
1 ½ Year 2.50%
2 Year 2.20%
3 Year 2.25%
4 Year 2.30%
5 Year 2.75%

The “blip” in this schedule is the 1.5 year term, yielding 2.5%. The basic short-term ING account offers 1.5% on cash. If you break the 1.5 year GIC, you receive a rate of 0.5% instead.

So what a GIC investor would do is ask themselves about liquidity – how much are they paying to sacrifice liquidity? The quick answer everybody would give is 1%, but this is not correct. The actual answer is that liquidity becomes much more expensive as the term approaches maturity.

For example, if you assume the baseline cash rate is 1.5% throughout the 1.5 year term, if you invested in the GIC and then canceled the next day, your liquidity cost is very minute. In the next month, your cost is still fairly minute – you are paying $16.67 per $10,000 to access your funds.

However, if you canceled 17 months into your term, the cost of liquidity would be much, much higher. Giving a numerical example, at month 17 of the GIC, your accrued GIC interest would be $354.17 on a $10,000 investment. However, if you had to break the GIC to borrow the money (for one month as you would ordinarily be able to access your funds on maturity one month later), you have suddenly paid $283.33 in implicit interest for a one month term. This is approximately an interest rate of 33.7% to access your own funds.

So a rational investor that is considering locked products with penalty for withdraw has to strongly consider any liquidity considerations closer to maturity otherwise they could be paying a very expensive liquidity bill.

Most people willingly give up liquidity for a low cost – don’t.

Yield chasers to be affected by long bond yield

If a 10-year government bond yielded 8%, and a fixed income investment in some corporate debt for the same term gave out 6%, what would you invest in? Assuming sovereign default is not an issue, every rational investor would take the government bond.

So the floor price for the corporate security would be a yield of 8%, if that security was perceived as having zero default risk.

It is likely investors would demand a premium over 8% to justify the extra risk that is embedded in the corporation.

However, if the government bond yield went up, the yield for the corporate security should rise an equivalent amount.

Finance textbooks would like to isolate this to a single variable, but the reality is not that clear – finance and economics are a multivariate game, and hence you cannot say that a 1% rise in government bond yields would result in a 1% rise in the corporate security. However, more often than not, you would see a rise of “around” 1% assuming default is not in play.

Since income-bearing equity is a perpetual claim on a corporation’s residual assets and cash flows, it would suggest that an increase in long-term government bond yields would also increase the yields on equity (hence, lower prices).

Paying attention to the Bank of Canada long-term government bond rate, currently around 3.6%, would partially explain price movements in very “yieldly” equities.

If long-term rates rise, yield chasers will be burnt. Your only defense – shorten your portfolio duration.

The difference between ocean and land freight transportation

Apparently ocean freight rates for various commodities are tumbling simply because of the supply of vessels available to transport such goods.

I know very little about the ocean freight industry other than that internationally based companies, such as Dryships (Nasdaq: DRYS) have exhibited considerable volatility as the market has boomed and now crashed.

The big difference between ocean shipping and land shipping is that inexpensive freight transit can only be performed by railways, while oceans are only limited by the number of ships you can manufacture and port facilities. Trucking is not commercially competitive with rail freight (except for delivery to the “last mile”) and as energy prices continue to rise, rail will continue to be very relevant in the future.

The two large Canadian companies in this space are CN Rail (TSX: CNR) and CP Rail (TSX: CP), both of which are trading at healthy, but not ridiculously overpriced valuations.

Davis + Henderson – Valuation

Markets indeed move quicker than most anticipate, and I can say the same for the common shares of Davis + Henderson (TSX: DH) as I have unloaded them today for a mild profit. Readers may recall my entry into the former income trust units, and partial sale in October of last year.

I have no concerns with the underlying business – although I have concerns with the speed of their acquisitions – it assumes that management can execute on proper integration. The balance sheet of DH is less than stellar, with about negative $224 million in tangible equity, but their debt levels (about $200 million in low cost debt) is manageable in relation to their cash flows (due for about $100 million after CapEx in the 2010 year). They will be giving off about $100 million in distributions to income trust holders in 2010, however. In 2011 the situation will change somewhat as they reduce distributions by 35% and will also incur an income tax (which will cut their cash flows by about 27-28%).

Most people will look at the headline yield number (roughly 5.8%), but the company should be evaluated on cash flow generation rather than the dividends they give out. On a free cash flow basis, they should be generating about $75 million after the trust conversion or about $1.39/share. Given their share price, this works out to a P/E of roughly 15, or a 6.7% combined yield. It is a healthy valuation considering the various businesses they are involved with.

The capital will likely be better invested in other options throughout the year but presently the pickings are slim on the Canadian side. I suspect 2011 will involve a lot of waiting.

It wouldn’t surprise me to see DH go up to $23/share if they show they have executed well on their acquisitions, but I’m happy to get out now – my initial valuations were also somewhat fuzzy since I don’t have a full comprehension of their industry. Most of the gains from the price they traded at after they did their corporate conversion plan have been realized with the existing stock price. No point in getting greedy right now.

For risk-takers only: Priszm Income Fund

The most troubled (but not formally bankrupt… yet!) company trading on the TSX is the Priszm Income Fund (TSX: QSR.UN), which operates fast food franchises. The fund owns 60% of a limited partnership that operates 432 restaurants (KFC, Taco Bell and Pizza Hut) across seven Canadian provinces. The other 40% is owned by a corporation controlled by the fund manager.

Unfortunately for the fund, they have substantial balance sheet issues. As of September 5, 2010, they have a $66 million loan that is secured by substantively all assets of the company, and this loan is due at December 31, 2010 (which was not paid). The company had $13.4 million in cash in early September, and cash through operations in the first 9 months of 2010 generated approximately $3.4 million. It should be noted the business is seasonal, with most of the revenues obtained in the third quarter (summer) season.

The company is trying to liquidate over half (232) of their restaurants, all located in BC and Ontario, for $46 million (link) but this deal has not closed yet. Even then, the company is not quite out of the woods in terms of their balance sheet situation.

Notably, the company has $30 million in unsecured convertible debentures outstanding that are due on June 30, 2012. The company has not paid interest on them at the end of December 31, 2010.

The debentures are trading at around 20 cents on the dollar, and have tanked over the past month as the solvency issue became very apparent:

This is a lesson for debenture investors that market valuations can be considerably divergent from the underlying truth – as early as the beginning of December, debentures were worth about 70 cents on the dollar – any investors at that point would have received a 70% haircut in valuation AND also the ignominy of paying the sellers 5 months of accrued interest!

It is also not quite clear even if the fund can realize $46 million in value out of the 232 franchises whether they will be able to avoid bankruptcy – they still have a considerable amount payable after this liquidation. Such a liquidation would occur on January 15, 2011 if approved by the buyer after they do their due diligence.

That said, it makes one wonder whether there is still value in the convertible debentures of Priszm. They are very cheap, but very cheap for a reason – even if the company can liquidate their franchises for an acceptable price, there is a stack of other payables that are due, possibly before or possibly jointly with unsecured debenture holders. Study up on your knowledge of the Bankruptcy and Insolvency Act! Suffice to say, this one would be for extreme risk-takers only.

Disclosure – No positions.