Canada – Page 46

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.

Fact checking on charities

In Canada, charities that are registered with the federal government enjoy certain benefits that other non-profit organizations do not. In exchange for being compliant with multiple government regulations, they have the ability of issuing tax receipts which equates to a refund of income taxes of 20.06% for the first $200 donated, and 43.7% for anything above that, using BC rates.

One of the items that a registered charity has to comply with is reporting to the Canada Revenue Agency so there is a degree of transparency where people can see where money is raised and spent within a charity. You can access this on the CRA Charities Listings site.

It is very important to know when an executive of a registered charity says that “We do not receive any government funding” that you check lines 4540 to 4560 on the return; if you see revenues there, the management is lying to the public. In addition, they are implicitly receiving government funding due to the value of the tax refund from charitable contributions. For example, if you were to donate $1,000 to a charity, your after-tax cost is actually $610.28. The federal and provincial government are essentially donating the other $389.72 in the form of an income tax refund.

Also there is the well-known issue of having a high percentage of money wasted on administration expenses. If line 5010 (Management and Administration component of total expenditures) and 5020 (Money spent to raise more money) are high compared to total expenditures in a charity, I would look at it as probable that they are not being efficiently run.

My advice would be to donate only to registered charities that you know at least one of the directors of, and your opinion of the director is positive. At least if they incompetently squander your money, you’ll be able to grill them in person and keep them accountable.

Canadian government firing a warning shot on real estate

Finance Minister Jim Flaherty made a statement on December 18, 2009 regarding maximum amortization periods and down payment rates. While I don’t have a copy of the statement or speech made, the National Post has a fairly good summary.

The salient detail is that the finance ministry might change the guidelines and decrease the maximum amortization period of a mortgage (currently 35 years), and increase the minimum downpayment (currently 5%). It would be likely that 30 year mortgages with 10% down payments will be the new rule.

The federal government is probably realizing that the CMHC has guaranteed a ton of debt and in the event of a Canadian real estate meltdown that it would have to pay a very heavy bill as people begin to default on underwater mortgages – this would occur when incomes do not rise to match rising interest rates. Most of the Canadian banks would get away with the financial damage, while CMHC would be paying the bill.

CMHC does collect a one-time insurance premium, according to this schedule:

Loan-to-Value	Premium on Total Loan		Premium on Increase to Loan Amount for Portability and Refinance
Loan-to-Value	Standard Premium	Self-Employed without third Party Income Validation	Standard Premium	Self-Employed without third Party Income Validation
Up to and including 65%	0.50%	0.80%	0.50%	1.50%
Up to and including 75%	0.65%	1.00%	2.25%	2.60%
Up to and including 80%	1.00%	1.64%	2.75%	3.85%
Up to and including 85%	1.75%	2.90%	3.50%	5.50%
Up to and including 90%	2.00%	4.75%	4.25%	7.00%
Up to and including 95%	2.75%	6.00%	4.25%*	*
90.01% to 95% — Non-Traditional Down Payment	2.90%	N/A	*	N/A
Extended Amortization Surcharges
Greater than 25 years, up to and including 30 years: 0.20% Greater than 30 years, up to and including 35 years: 0.40%

So let’s pretend you buy some Yaletown condominium for $400,000 and decide to pay 5% down and a 35-year amortization. Your insurance premium, with a verifiable income, is 3.15%, or about $12,000 for the right to have your bank protected in the event of you defaulting on the $380,000 mortgage.

If the rules change to 10% down and 30-year amortization, the CMHC premium goes down to 2.2%, or about $7,900 on a $360,000 mortgage. Strictly looking at the premiums, it would suggest that changing to a 10%/30-year system would reduce defaults by 30%.

The problem deals with correlation – if one mortgage defaults, it is more likely that others will in a cascading line (mainly because CMHC will have to sell the property in order to recover as much of the defaulted loan as possible, depressing the market, and likely causing other strategic defaults). It doesn’t matter what caused the default, but my prime hypothesis is when people go and get their 2% floating rate mortgages, when the Bank of Canada starts to raise rates in the middle of 2010, people will be facing double interest payments when they haven’t properly budgeted for it.

There is also the batch of people that got low 5-year fixed rate mortgages facing renewal – right now 5-year fixed rates are still at relatively low rates (3.8%) but the party will end.

The finance ministry is just trying to make sure the party ends slowly (by people paying off their high-leverage loans over a long period of time), instead of the cops coming in and storming the house (if people can’t pay the interest on their high-leverage loans and cause a cascading default). Jim Flaherty probably knows this is a financial time bomb that can potentially go off if the wrong circumstances hits the economy, and is taking preventative medicine to do so.

CMHC mortgage bonds currently trade like fixed income government securities. You can see a chart of mortgage bonds outstanding on this chart.