Replacing ING Direct

The place where I normally park cash is in ING Direct, which has been a mainstay financial institution for myself for a very long time. When they first opened, they were by far and away the best place to park cash. Now they are a mediocre offering of the many online products that are available out there. I am guessing that they achieved their desired level of deposits and have achieved their desired debt-to-equity ratio with their residential mortgage offerings.

ING Direct hasn’t contaminated their customer experience by spamming their customer base with too many useless services, but this encroachment to simplicity has been eroding at a faster pace as of late – see my post about RSP loans, for example. It is simplicity that has caused me to stick around with ING Direct instead of shopping for other services. However, that time has now come.

So today I sent in a cheque to Ally, which used to be known as GMAC. Obviously since GM tarnished their brand with their bankruptcy filing and investing money in an institution that shares the same name with a bankrupt entity doesn’t inspire much confidence, they changed their name in 2009. In Canada, they are run by a firm called ResMor Trust Company, which otherwise does mortgages. In any event, they are CDIC insured and this means that the taxpayers of Canada will be picking up the guarantee for deposits up to $100,000.

Since I will not be depositing more than $100,000 in Ally, the safety issue of the institution is more or less mitigated.

Their peak offering is a savings account which delivers 2% interest (which is subject to change at anytime), but since this is significantly higher than ING Direct’s offering at 1.2%, it is a trivial process to click a few mouse buttons and transfer the money. Every dollar counts.

As interest rates rise, it will be interesting to see the spread between these two institutions since they are competing for the same bucket of capital from Joe Saver.

Canadian Interest Rate Projections

The financial media is catching wind that interest rates are going to be increasing. Although I believe the Bank of Canada is fairly firm in holding their overnight rate at 0.25% until the end of June, the question remains how much they will raise rates in July. I thought that it was going to be an evolutionary 0.25% increase over the next scheduled meetings of the central bank, but there might be a larger jump.

Futures markets are signaling the following compared to the same time last month (January 2009):

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 MR 0.000 99.545 99.550 99.550 -0.005 4412
+ 10 AL 0.000 0.000 0.000 99.510 0.000 0
+ 10 MA 0.000 0.000 0.000 99.460 0.000 0
+ 10 JN 0.000 99.400 99.410 99.410 0.000 16860
+ 10 SE 0.000 99.030 99.040 99.030 0.000 19502
+ 10 DE 0.000 98.630 98.640 98.630 0.000 17457
+ 11 MR 0.000 98.240 98.250 98.250 0.000 2335
+ 11 JN 0.000 97.900 97.920 97.910 0.000 1360
+ 11 SE 0.000 97.550 97.620 97.600 -0.010 175
+ 11 DE 0.000 0.000 97.350 97.300 -0.050 56
+ 12 MR 0.000 97.000 97.090 97.050 0.000 0
+ 12 JN 0.000 96.740 96.870 96.810 -0.040 7
+ 12 SE 0.000 96.530 96.670 96.600 -0.030 7
+ 12 DE 0.000 96.320 96.500 96.370 0.030 7

We can see the projected interest rate for December 2010 is 1.36%, while December 2011 is around 2.7%.

Another metric to look at is long term bond rates – 5-year bond rates (which determine how expensive 5-year fixed rate mortgages will be) are currently trading at 2.56%, but this has not changed too much over the past half year.  If the markets were anticipating significant amounts of inflation, they would most likely hit the longer term bond markets first.

The expectation theory states that long term rates are a representation of the short term rates that will existing throughout the maturity of the debt.  As such, the markets are expecting an average of 2.56% over the next five years – since rates for the next 5 months will be at 0.25%, it hints there will be a period of time where we will see short term rates at or around 3%.  Interest rate futures say this will be around March and June of 2012.

My financial crystal ball suggests that the markets are pricing this in correctly.

Since the yield spread (between the 10 year and 2 year bond) is around 2.1%, it does suggest that there will be some sort of economic recovery – my sense in terms of how to play this is to load up on commodities until the yield curve flattens.  When the yield curve flattens, the party is over.

Canada Pension Plan, Q3-2010

The Canadian Pension Plan reported its fiscal third quarter, with a 1.8% return on investments between October 1 and December 31, 2009. The asset mix of the fund is as follows:

* Equities represented 56.1 per cent of the investment portfolio or $69.5 billion. That amount consisted of 43.9 per cent public equities valued at $54.4 billion and 12.2 per cent private equities valued at $15.1 billion.
* Fixed income, which includes bonds, money market securities, other debt and debt financing liabilities represented 30.0 per cent or $37.3 billion.
* Inflation-sensitive assets represented 13.9 per cent or $17.2 billion. Of those assets,
o 5.8 per cent consisted of real estate valued at $7.1 billion
o 4.9 per cent was infrastructure assets valued at $6.1 billion
o 3.2 per cent was inflation-linked bonds valued at $4.0 billion.

The TSX reported a 3.1% gain over the same period of time, so when one considers their asset mix (together with the fact that fixed income yields have slightly risen, thus resulting in value declines), the CPP had an average quarter.

The CPP requires a 6.2% nominal rate of return (4.2% real rate) in order to meet its long term investment objectives. While this number is realistic, it will also be challenging to realize these returns strictly within the North American confines – in order to achieve disproportionate returns, the CPP investment managers need to be looking abroad. Investing outside your known jurisdictions, however, can be very hazardous to your financial health, so I hope these guys know what they are doing.

Since April 1999 the CPP has realized 5.3% nominal returns, which means they are trailing by about 15% when you do the math – the actuary will likely have to boost the target rate of return needed to keep the CPP solvent to around 6.4% in order to catch up.

Still, the CPP is light-years ahead of the USA equivalent, social security. Canada did most of the heavy lifting on this issue in the 1990’s and it is one of the unspoken achievements of the Jean Chretien administration to put in a relatively permanent fix to this issue.

Knowing the difference between cash and income

One of the most powerful concepts that most beginning investors confuse is the concept of cash flow, and the concept of net income. In capital-intensive industries, an investor must know enough about the underlying accounting in order to make a proper investment decision.

Probably one of the easiest textbook cases for this concept is looking at the year-end report for Sprint Nextel Corporation. For 2009, they reported a net loss of $2.44 billion, but generated about $2.7 billion in cash at the end of the day.

The simple reason for this is that the company made huge investments in telecommunication assets in prior years and is continuing to depreciate those assets – the actual cash has been long since paid and as such, the depreciation expense does not represent a cash transaction.

So while Sprint will be reporting net losses for the foreseeable future, the company will still be generating cash to pay off its debt. Eventually this process will stop when the assets have been further depreciated, but it is up to an investment analysis to decide whether the company will put more cash into more capital projects, or whether to milk their existing investments and just spend money on maintenance.

Telecommunication companies, in this respect, are relatively easy to analyze.

Finally, as a bondholder in Sprint, all I am concerned about is their ability to service debt. The company does not pay a dividend and at the rate they are able to generate cash, will be able to service their debt for the foreseeable future. Back in October 2008 and March 2009, I was busy picking up equivalent units of debt that will continue to give off insane returns on investment (averaging roughly 18% in coupon payments and 5% in annualized capital gains upon maturity). There is no chance that equity will be able to repeat this at the risk I am taking!

Even today, such units are trading at about a 9.3% current yield, and about 1.9% capital growth to maturity, which is likely better than what you would get from equity over the next 19 years.

The Canadian version of Prosper – CommunityLend!

I couldn’t help but notice that I signed up some time ago to be informed when Canada’s peer-to-peer lending service, CommunityLend, would go active. The service is otherwise very similar to that of Lending Club and Propser – people can bid on other people’s loan requests and the lenders get charged a 1% fee on the money they receive, while the borrowers have a significantly larger charge depending what credit bracket they are in. On the front page of CommunityLend, they advertise that you can borrow money with a 6% to 29% return:

Right now you can only lend money through CommunityLend in the provinces of Ontario and Quebec, although they are trying to expand to other provinces. The other hitch is that you have to be an “accredited investor”, which is a securities legislation definition of an investor that can legally purchase securities while waiving the standard legal protections that you would otherwise get if you weren’t exempt from the accreditation criteria.

The only issue for CommunityLend is that the easiest way to qualify to being an accredited investor is having net financial assets of greater than $1,000,000, or to be a registered adviser. Just by this stratification, which was likely discovered during the consultation process with the respective provincial securities commissions, the lenders are going to be a much smarter breed of people. Judging that the risk taken by people using the Canadian peer-to-peer lending facilities aren’t going to be any less riskier than those using the US equivalents, I would guess that interest rates received on loans will be slightly higher simply because you will have less people bidding rates down.

My prior statement about peer-to-peer lending remains the same:

There is educational value for people to invest small (and I mean small) amounts of money just to demonstrate how difficult it is to make money even when allured with the promise of high rates of return. Instead of a return on capital, the return of capital becomes paramount in the loan business.

Just to give future investors some sort of barometer, you can pick up corporate debt from relatively stable and smaller publicly traded corporations with a 3 year maturity for about a 9% yield to maturity. Thus, anybody bidding for unsecured consumer debt at a 6% interest rate should get their heads checked.