Ally doesn’t inspire confidence

I’ve written about Ally before and for the most part they have performed in a minimalistic manner, which is what they should be doing. They still have a fairly high short term savings rate (2.00%) and this is only overshadowed by a couple other obscure institutions offering 2.1%.

On their high interest savings page, I saw the following:

So is it 2% or 1.75%? I logged into my account and indeed, it was 2%.

Stuff like this makes me look at the CDIC page and read out the following passage to myself:

CDIC automatically insures many types of savings against the failure of a bank or financial institution that is a CDIC member. However, NOT all savings are insured and CDIC deposit insurance does not protect against fraud, theft or scam.

I’m really beginning to wonder if a bank failure was caused by fraud whether that would count. I don’t think it is the case for Ally, which is owned by ResMor Trust Company. In the USA, the Ally brand used to be backed by the General Motors Acceptance Corporation, while in Canada, ResMor Trust Company is a mortgage firm – very similar to ING Direct’s business model except that ING Direct uses the same name for both savings and loans.

LuluLemon’s second quarter

Headlines are being made that Lululemon (Nasdaq: LULU) beat earnings expectations and raised income estimates for the year. Their common shares were up about 13% today after their second quarter report.

Most of what I wrote about Lululemon, in terms of share valuation back in June 10, 2010 (when they announced their first quarter results) applies today – the company will have to execute high growth perfectly in order to justify their existing valuation.

It should be pointed out that despite their second quarter surprise, their valuation around the same ($2.8-$2.9 billion) as it was when I wrote my June 10 article, or about USD$40/share. They will need to continue achieving rapid growth in order to grow into the existing valuation. If not, you will see a significant haircut in the stock price.

Lululemon is a classic case of a well-run company that you do not want to own stock in.

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!