Debt investing advice

The reason why debt is valued more highly than equity, thus giving off a smaller yield, is because of its higher ranking in the seniority chain. If the company fails to pay interest and principal according to the terms of the debt agreement, then the debtors will usually be able to take some equity stake in the firm after a bankruptcy proceeding.

The tip of the day is not to invest in an entity where it is mandatory for the existing equity owners to maintain control of an organization in order for it to operate. The leverage the debtholders have in such a situation is precisely none – if they force the organization into bankruptcy, they will be left with nothing, while if they do not, they will still be left with nothing except a promise to be paid.

A debtholder needs more than a promise to be paid – they need the ability to force the company into bankruptcy or liquidation if a default occurs.

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.

Chasing yield is easy until the party ends

I have successfully liquidated my debentures in Harvest Energy (series D and E) for 101.5 and 102.0, respectively. Since they are trading above the 101 that will have to be offered after the takeover, it is unlikely that investors will tender the debt. I am happy to be rid of the bonds so my capital can find some more productive areas. My opportunity cost of this transaction is giving up about a 6% yield, but there are equivalent risk instruments that the money can be parked in the interim.

I have another issue (Bellatrix Exploration, formerly True Energy Trust) that has seen its equity rise about 400% over the past four months and its bonds have correspondingly traded near par. It is very close to my liquidation point and there will be a high probability it will be sold very soon.

As such, my portfolio is starting to look cash rich. While cash is good, it is also earning a return that is less than flattering (mainly zero) and while I can shift the funds into a short term savings account for 1.2% (or 2% if I shopped around) I am always looking for a better place to put my money – something that will give a yield.

In my tax sheltered accounts, I am looking for investments that will generate income. Outside the tax sheltered accounts, I am looking for investments that can generate capital gains (taxed at half the rate) or eligible dividends (taxed significantly less depending on what income bracket you are in).

Most of the income trusts have been bidded up to yields that are not representative of the risks embedded within the company – for example, a trust that is always on my watchlist (but I never get around to purchasing) is A&W – currently yielding about 8.01%. This is not adequate compensation for a company that is distributing more cash than its distributable cash allotment. It is possible that A&W could trade higher (and yield lower) but this is essentially the equivalent of gambling and could just as easily go to 8.5% ($14.82/unit) as it could to 7.5% ($16.80/unit). I do not want to get into coin flipping competitions with the market.

Since my hurdle rate is above 8%, I am forced to lower my standards if I am to seek a home for my cash. This means either accepting higher risk, or accepting a lower rate of return.

Right now if I accepted a lower rate of return, I estimate I could generate about 10% a year with debentures, but this is still a relatively low rate of return in consideration of the risk taken.

As such, I must broaden my search to more obscure securities and companies. This will also require some research and time. It will also require appropriate market conditions when people are less confident.

Fortunately, time is on my side – while the cash is sitting there, earning nearly nothing, it will at least be there when I need it. The temptation to quickly deploy cash is one of the most destructive psychological behaviours one has while investing.

An inflation-protected investment

This does not scale up beyond a couple hundred dollars, but if you are planning on sending a large quantity of first-class letters across Canada, investing in some stamps is not a bad method. Currently stamps are 54 cents and are marked as “permanent” which means that the face value of the stamp will increase as prices increase. Stamp prices will increase to 56 cents in 2010 and 58 cents in 2011.

Implicit in this price increase is a 3.7% protection against price increases in the future. Since interest rates are currently well below this figure, there is a minor amount of inflation-proofing available to buy stamps now for the next few years.