Category: Canada

Best places to park short-term, nearly-risk free Canadian cash

As a result of the Bank of Canada’s decision to hold the overnight interest rate target at 0.5%, options for Canadian dollar cash balances are bleak.

Cash can always be held at zero yield and would be immediately available for deployment.

There are also financial institutions that will allow you to lock your money in for a 1-year GIC and earn around a 1.25% risk-free return. However, the sacrifice in liquidity in the event that you would want to deploy such capital is unacceptable from an investment perspective. One can also purchase a cashable GIC (typically redeemable within 30 days after purchase) that earns slightly less yield – my local BC credit union offers such a product with a 0.85% yield.

I was curious as to the best exchange-traded products that would offer some yield at the lowest risk.

There are basically two options. They are (TSX: XSB) and (TSX: VSB). Both are short-term government bond funds. VSB is significantly cheaper on management expenses (0.11% vs. 0.28% for XSB), and both portfolios offer similar durations (roughly 2.8 years), and VSB has slightly better credit quality (55% weight to AAA instead of 50% for XSB). VSB should eventually have a better net yield after expenses (roughly 1.1%) due to the smaller MER. While the 1.1% net return is small, it is better than zero and is nearly risk free – there is anti-correlation between general market movement and the likely price movement of this fund – the capital gain on VSB should rise if there was some sort of crisis due to the heavy government bond exposure of the fund.

Another alternative which is deceptively cash-like but will not serve any purpose if you wish to save money for some sort of financial crisis is the high-quality corporate bond fund also offered by Vanguard (TSX: VSC). Although VSC will offer you another 80 basis points of yield, it has the disadvantage of likely having a liquidity premium in the event there was some adverse financial event – i.e. your cash-out price will likely be materially less than NAV.

All three ETFs trade at modest premiums to NAV.

Canadian interest rates

The Bank of Canada dropped their target interest rate from 0.75% to 0.5% today.

Canadian currency has taken a plunge in response. In addition the Federal Reserve Chair has pledged to start “normalizing” US interest rates by the end of this year which also puts downward pressure on all non-US currencies.

cdw

While I rarely have strong feelings on currencies, the “perfect storm” for the Canadian dollar is brewing (lowering interest rates, lowering GDP, lowering commodity prices, lowering external trade with China/USA, political uncertainty over the October 19 election) and it appears more likely than not that we’ll start approaching the point where we’ll see some sort of floor on Canadian currency (simply because the news could not get worse). I’m going to guess it will be around 72-74 cents, but we will see. I’d also expect this low to be reached around October and I may make a significant policy change on my CAD-USD holdings at this time given valuation levels.

My working theory is that the US economy is going to have extreme difficulties adjusting outside of a zero-rate environment and the process of deleveraging will be a painful business when hedge funds can no longer obtain money for free (Interactive Brokers, for example, will happily lend you USD at 0.63% for more than a million and 0.5% for more than $3 million). Paradoxically if the 30-year treasury bond decides to spike up from 3.2% to around 3.5% yield levels, I would suspect that purchasing long-term treasuries are going to be the winning play over the next period of time – not any equity fund. Debt levels incurred by the US government are hideously high and with every quarter point increase that they face will be a disproportionate amount of interest expense going out the door.

This also does not factor in other entitlement spending (e.g. social security, medicare, etc.) that serves to effectively ramp up the net expenditures for public debt purposes.

Right now I am mostly cash (or near-cash). Some of my efforts to find a place to park cash have mysteriously yielded results that are relatively low risk and I’ll be able to realize a modest single digit percentage at the cost of a little bit of liquidity, but in the event there are better investment opportunities on the horizon I will be in a very good position to pounce.

Maybe I should have invested in the CPP instead

The Canada Pension Plan reported a 2015 fiscal year-end (their fiscal year goes from April 1 to March 31) performance of 18.7% gross, or 18.3% net after fees.

Over the past 10 years, the CPP has realized a 6.2% real rate of return, while in order to remain sustainable they require a 4% real rate of return. When dealing with a $250 billion dollar fund, two percent compounded over 10 years makes quite a big difference.

I have had my doubts that the CPP would be able to realize increased returns as it grew simply because they are competing with a lot of other big players for the same pool of income. In a smaller scale, individual investors have to scour the beds of the financial oceans in order to find reasonable risk/reward opportunities.

There is likely going to be increased political pressure to either reduce CPP premiums or raise CPP benefits due to the outperformance of the CPP. It is likely such a decision would be a mistake because in the macroeconomic sense, central bank quantitative easing has inflated asset pricing to extremely high levels. It is very improbable the CPP can maintain its current performance and quite probable that they will pull in more “real-world” rates of returns (i.e. single digits).

However, all Canadians should be happy that the CPP is doing what it did – there is this pervasive myth that the CPP will not be able to pay out for existing and future generations and with the existing payment and benefit regime it is quite likely they will be able to pay for the indefinite future. Assuming you have made maximum contributions to the CPP, you would be entitled to a $12,780/year retirement benefit when you turn 65 years of age. While this is not a huge amount of income, when coupled with Old Age Security ($6,765/year) leaves approximately $19,500/year of pre-tax income which, if properly budgeted, will pay for a basic lifestyle in retirement.

Inverted yield curve

The Canadian bond market is exhibiting a very minor instance of an inverted yield curve between short term and 2-year money. You can view interest rates here.

This is a good an indication as any that we’re going to touch upon a zero GDP growth cycle coming later in 2015 and perhaps negative. Pull out the textbooks to see what industries are good to invest in a recessionary climate.