With the US Federal Reserve imminently seeking to drop interest rates, and the Bank of Canada dropping rates a quarter point a meeting, earnings on cash are starting to decline, and all of the below will head down proportionately to the central bank rate:
(All of this assuming you can buy it at NAV)
CAD-denominated:
IBKR = 3.575% net [interest, minus CAD$13k]
HSAV.to = 3.93% net [cash, capital gains]
CASH.to = 4.02% net [cash, interest]
ZST.to = 4.34% net [6 month maturity A-AAA bond income, mixed interest, capital gains]
USD-denominated:
IBKR = 4.83% net [interest, minus US$10k]
HSUVu.to = 5.02% net [cash, capital gains]
In the Canadian market, the futures are aligned for a 25bps drop on October 23, December 11 and January 29, which will bring cash down from 5%+ to just above 3%. That will be roughly a 40% drop in income on cash in about three and half months’ time.
Needless to say all of this central bank action will be getting participants to examine the “efficient frontier” in terms of adjusting their risk-reward profiles. Instead of getting a slick 5% on risk-free cash, we will now have to explore upwards to short-term bonds, and less credit-worthy financial instruments to achieve the same amount of returns.
Unfortunately the financial markets, by virtue of future contracts, already anticipates these interest rate changes and hence anything that can provide as a substitute has already been bidded up. For example, the GoC 5 year yield from July 1st to today has gone from 3.6% to 2.8% (people will pay a premium for five years of guaranteed yield vs. a higher short-term cash yield). The Canadian preferred share market has been bidded up across the spectrum – for example, we will choose a generic preferred share, PPL.PR.O, which is trading at a 6.9% current yield and a 6.4% yield at the current GoC 5yr rate reset (essentially the risk premium is you will get an extra 3% or so for taking some duration and credit risk).
Bond-like equities also exist. Rogers Sugar (TSX: RSI) has always been one of my favourite barometers of a very stable and government-protected market in domestic sugar and their equity yields 6.4% and they pay out nearly everything in the form of dividends.
Royalties are another stable category of income. For example, Keg Royalties (TSX: KEG.un) which is a very simple income trust that takes 4% of the top-line revenues of all Keg restaurants in Canada, gives out a 7.7% distribution yield at their current payout. If you had invested in early July, this would have been a 8.7% distribution yield.
If one were to achieve a 15% return, there is nothing invest-able mentioned in this post that you can do other than to leverage up – for instance, borrow at 5% to obtain a 6.4%, 6.9% or 7.7% return – either way it is a pretty thin margin.
Needless to say, returns on risk right now are awful. Returns above the numbers presented in this post will be coming from speculative capital appreciation which makes the current environment feel more like gambling at a casino than actually investing.
There are other targets of opportunity which I have not mentioned in this post which have a little more potential, but I am still patiently waiting for a little more market stress to occur and hopefully there might be a margin call wipeout or something, just like when the Nikkei cratered 13% in one day – an event that seems to be a distant memory now.
“people will pay a premium for five years of guaranteed yield vs. a higher short-term cash yield”
Or, in other words, people will accept a lower yield if the duration is longer. This is, of course, the inversion of the yield curve in action and which is in the (super slow) process of normalizing.
The vast majority of the Cdn preferred share market are fixed reset preferred shares (dividend is reset every five years at a spread to the GOC 5 year bond). Normalization of the yield curve and a return to a more “normal” investing environment will lead to a lower spreads demanded in the market.
In late October last year (before rate cuts became generally accepted as on their way, a new preferred issue by BN (for example) would have required a spread of 7.3%. Today that spread is 4.0% which proves your point about preferred shares being bid up. For those that believe that further spread compression is likely (I do) as the yield curve normalizes, there is a capital gain component remaining in the mix for this asset class.