Category: Finance

Here are some indicies and their year-to-date performances:

Equities
S&P 500: +4.1%
TSX Composite: +7.2%
Nasdaq Composite: +1.6%

However… the winner so far is bonds!

iShares 20+ Yr Treasury Bond ETF (NYSE: TLT): +12.0%

Who would have ever thought?

Just put yourself in the shoes of this person – your pension plan has an expected rate of return on plan assets of 7.1% and your actuarial balance is 90% of funded levels for your plan because of weak market performance.

I picked 7.1% because this is an example of a large-scale pension plan (the British Columbia government, for example – others may vary).

How do you allocate to get a 7.1% return?

Perhaps investing in high quality fixed income – even if you’re the world’s best bond trader and get a 200bps spread over Canadian government bonds on A and AA paper (which you are functionally restricted to in your pension plan), you are still well below the 7.1% threshold.

In fact, simple math would state that if you are 50% allocated in high-quality fixed income (let’s just use Genworth MI’s latest A/AA bond offering as an example – 10 years and 4.24% yield), you still need an allocation of equity that would net you 9.96% to “break even” on your 7.1% expected rate of return.

So obviously the deeper the portfolio dives into high-quality fixed income, the higher the return it needs from other components, which would likely come from equity and further up the risk spectrum.

Further up the risk spectrum are BBB bonds, which is the lowest rated bonds that most pensions are allowed to invest in. The yield premium you get on these versus A/AA investments is presently not much better (a lot of low quality debt is trading as if it is a guarantee), but you incur the risk of defaults down the line (in addition to illiquidity when you’re trying to unload them).

Finally, any bond trader will point out to a yield graph and show you that long-duration bonds are trading at high levels (low yields). Probably the reason why most high-quality fixed income continues to trade at low yields is that whenever yields do pop up, they are snapped up by institutional managers that want to fill in that income component of their asset allocation models.

The point is that while historically you could have run a pension plan in the 1980’s to about the year 2005-ish primarily investing in long-dated high quality fixed income securities, today that is clearly not possible.

The other component is typically equities, but an institutional manager will look at the graph of the S&P 500 (trading at all-time highs never seen before in the index) and ask themselves whether they can squeeze more than their 7.1% threshold out of the index when it is trading so high. Nope! Can’t invest here! Additionally, lower sub-indicies such as the S&P 400, and the smallcap S&P 600 are less liquid. Just as an example, the S&P Midcap 400 index has a market capitalization of about $1,600 billion at present. For smaller players this is liquid, but for larger players (e.g. if you have a $200 billion pension plan), it would move the market.

So you move up the risk spectrum, get into junkier debt issues and “alternative investments”, the latter of which is a codeword for illiquid and speculative. They also are cursed by the fact that there is no active market trading on things such as toll roads and other public-private partnerships, and that these investment decisions have to be made very, very carefully made in terms of valuation and expected business results. Still, institutions that need to do higher-yielding investments in size have to venture into these speculative ventures.

So all-in-all, the low-yield environment we are currently in is a function of yield demand – institutions around the world are starving for yield and they are willing to take more capital risk to achieve it.

The smaller individual investor, however, should figure out where the demand is not located and there should be a higher probability of value being located at such points.

Something that always is a pet peeve is currency exchange fees.

As I type this, Interactive Brokers can give you currency spreads that are enormously small:

If you want to buy USD$100,000 it would cost you CAD$108,760. If you wanted to sell USD$100,000 you would receive CAD$108,755. The spread is next to nothing.

We compare this to a typical credit union that posts the following rates:

Although I am reasonably sure the bank would give you a “discount” rate if you dealt with higher currency volumes, at their posted rates that USD$100,000 would cost you CAD$111,550 or about $2,790 difference from Interactive Brokers.

It is a simple procedure to get the cash out from the bank once you beam it from IB. Due to the miracles of margin accounts, you don’t even have to explicitly convert the currency – you just withdraw the amount and deal with the debit balance later (if you do not already have the US cash on hand).

When dealing with small amounts (e.g. less than $100) it is generally immaterial to pay the $3 or so compared to going through the optimal route, but when dealing with larger quantities of money, exchange fees add up considerably.

Most credit cards will do an exchange at the legitimate market rate, but tack on a 2.5% or 2.9% currency exchange fee. There is only one company that I know of in Canada that does not charge such a fee, and that is at Chase Canada. Unfortunately their cards in question are lacking in any other features that would make this useful for anything other than foreign credit card purchases. However, if you know you are going to spend a significant amount of money outside of Canada using your credit card, then these cards in themselves would constitute an implicit “reward” of the 2.5% or 2.9% currency conversion fee that you would otherwise be charged.

There’s more media sensation over the Investor’s Group offering a 3-year prime-minus 1.01% variable rate mortgage (which gives a snazzy 1.99% headline).

The rest of their rates are fairly mediocre, so this is clearly pure marketing instead of them trying to invade the mortgage market. The three-year government bond yield is 1.17% and they will pocket the (albeit) smaller spread. After three years, they’ll try to convert those mortgages into a high-cost fixed rate mortgage or some other product.

But it leads to the question of – let’s say you had access to capital for three years at 2% (assuming those short term rates don’t rise!). The number of safe investment harbours to earn a larger spread is definitely diminished.

So where do typical retail people put low-cost capital? The answer seems to be pretty clear – housing. For that matter, institutions are pouring it into almost everything other than cash – anything with a yield, including equities and bonds, have been bidded up substantially. Financial assets are quite expensive.

Another source of cheap credit is Interactive Brokers, assuming you can post the appropriate equity security to back the margin loan. Canadian dollars right now are 2.5% for up to $100,000, 2.0% for up to a million, and 1.5% after that.

The one thing about accumulating debt is that you’ve got to pay it back. Leveraging when the stock market is at all-time highs and yield spreads between AAA debt and junk bonds are at a minimum is not the world’s best formula to get rich.

As you might tell by the tone of this post, the pickings are slim out there. Almost anything worth speculating on (i.e. with cheap prices) has considerable baggage.