How can small business deal with today’s currency fluctuations?

Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.
Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.

Right now it’s no secret that selling merchandise to Americans is pretty lucrative.  We also know that it hasn’t always been this way.  A relative of mine who sells lighting products to customers the U.S. is a case in point.

My brother-in-law built a very successful business with his wife from the ground up.  Their decision to sell to markets in the US worked fine, but the real boost to sales occurred when their son joined the business and talked them into selling on the Internet.  Online sales boomed, but of course so did their company’s vulnerability to exchange rate risk.

A few years ago, he was struggling to make his usual margins (which are not that big at the best of times) when the CAD/USD exchange rate approached par.  In other words, a C$ was pretty much equal to the US$.  Cross-border shoppers from the Canadian side of the border were in heaven (myself included), whereas exporters were beginning to panic.  After all, their costs were still in Canadian dollars, which was an advantage when they received sales revenue in a much stronger $US.  Converting back into Canadian currency provided a substantial bonus to their profits and quality of life.

Things are great once again, but how can a smaller business owner(s) plan ahead to make sure that currency risk doesn’t threaten their livelihood?

The graph below illustrates the impact currency can have on a business.  Imagine a fictional Canadian company that began selling a specialty cheese to the U.S. marketplace in June of 2006. The sale price stays the same (due to competitive pressures) at US$ 2.50.  Costs are steady in C$ 1.98 range.  Sales made in US dollars must be converted back to Canadian dollars.  
USD-CAD sales and profits
It is easy to see how just the exchange rate can wreak havoc on a businesses revenues and profitability.  Is it possible to anticipate or prevent this volatility?  When companies are accustomed to very large orders, it is possible to contact your bank and make arrangements to use the currency forward markets in order to ‘hedge’ your profits.  For instance, if one expects to have to convert a significant amount of foreign currency into one’s domestic currency once the order is delivered, you can arrange to lock in the forward exchange rate today, thereby knowing exactly what your margin is (and will be).

However, the orders for most small businesses aren’t large enough to make hedging a viable option. Can you plan for currency fluctuations?  Experts agree that there is no robust way to forecast exchange rates.  Experts have been frustrated trying to predict exchange rates for years, and the forward markets/futures markets are not very good predictors of the exchange rate that will actually occur in 3 to six months.

One approach that has been around (seems like forever) is the purchasing power parity theory.  The price of a consumer product (same materials, can be sourced locally or at same prices) should be the same in different countries, once adjusting for the exchange rate.  Below, the table compares the price of the rather ubiquitous iPhone in Canada, Europe and Asia.  The price of the iPhone 6s 16GB (unlocked) in the U.S. is about $699, and should be more or less the same in Nanjing, China (their currency (is the remninbi or RMB) adjusting for the exchange rate as it is in Berlin Germany (euros).  As you can see from the table, this is not the case (the prices and exchange rates are not 100% accurate due to rounding).

iPhone intl pricing

Because Germans and the Chinese have to pay an even bigger price, it suggests the the USD is overvalued relative to those currencies.  The Canadian dollar on the other hand, based on this overly simple approach is actually still a bit overvalued compared to our neighbour to the south even at these depressed levels.  Of course, our proximity to the US might simply give Canadians a great deal on iPhones not available in other countries.

We should therefore expect the USD to depreciate relative to both the EUR and RMB in due course – the forces of supply and demand (for products, services and therefore currencies) should cause disparate prices to equilibrate.  The mobile device in theory should cost the same to the consumer no matter where he/she lives.  Should the USD decline significantly (perhaps even compared to the Canadian dollar) then the margin on good and services businesses in those countries are earning today with decline.

When sales are in another currency

The problem, is that historically purchasing power parity is also a poor predictor of exchange rates. The game of international finance is extremely complex.  Not only are exchange rates determined by differing interest rates in countries, balance of payments, trade balance, inflation rates and perceived country risks, the rates are also influenced by expectations associated with these variables and more.  The bottom line for smaller businesses is that when it comes to foreign exchange risk – they are completely exposed.

So what can be done?  Planning.  It is tempting to become overly optimistic when exchange rates have drifted in your favour, encouraging further investment to facilitate more sales in the stronger currency.  Buying equipment, hiring permanent labour and leasing more space introduces higher fixed costs that might dampen or destroy profitability when the tide turns the other way.  It is important to consider ‘what if’ scenarios frequently – and especially before laying out more capital. For entrepreneurs the biggest mistake is to take for granted that the status quo will continue.  All of a sudden, you might be buying yourself a bigger house, a fancier car and sending the kids to private school – all based on current income which is linked to the current prosperity of your business.

Currency instability is a fact of life, and the best way to be prepared is to expect the inevitable. Rather than rush to spend more on expanding the business put aside a ‘safety’ cushion during good times that can be drawn upon during bad times.  If your commitment to the US, European or other markets is firm, then park the cushion into currencies you are vulnerable too.  For example, invest your cushion in US dollar denominated assets – U.S. Treasury bills will provide a natural hedge for your sales.  Similarly, if a significant volume of your sales are in Europe and the company borrows funds for operations, borrow some funds in euros as a hedge – then if the euro appreciates you’re able to pay those obligations in the same stronger currency thanks you your euro receivables.

It is widely believed today that the USD is likely to depreciate relative to a number of other currencies, and perhaps imminently.  Today might indeed be the ideal time to begin considering ‘what if’ scenarios and the actions you can take to plan ahead.

 

 

Income Investing: “Feed Your Head… Feed Your Head”

Jefferson Airplane has never, ever, been mistaken for a band of financial advisors, but the White Rabbit lyrics can be incredibly instructional to the generation of investors who experienced the classic first hand — as a description of their own college days’ lifestyle. If only they had heeded the dormouse’s call to “feed your head.” For the sake of your retirement sanity and security, you just have to make income investing an intellectual exercise — not an emotional one.

The Brainwashing of the American Investor has its own tale of an Alice whose “logic and proportion” had “fallen sloppy dead”. Many years ago, when interest rates soared into double digits, elderly Alice was well advised to invest her stash in a portfolio of Ginnie Maes. Broadly smiling, she bragged to her friends about the federally guaranteed 13% interest she was receiving in regular monthly intervals — much more than she needed to cover her living expenses.

But interest rates continued to move higher, and the decreasing market value of her Ginnie Maes was more than she could tolerate. “If rates continue to go up, I’ll have nothing left” she cried to her White Knight financial advisor who suggested patience and understanding. The very same pill that made her income grow larger was also making her market value become smaller.

Yet the income kept rolling in, higher yielding unit trusts were purchased with the excess, and major redemptions were nowhere to be seen. The income kept growing, the market value kept shrinking, and Alice was seeing red from seeing red on her account statements.

So Alice went to her local bank and traded in her absolutely government guaranteed 13 per centers for some laddered, non-negotiable, 8.5% CDs. “No more erosion of my nest egg”, she toasted proudly with the hookah smoking bank caterpillar who orchestrated her move to lower income levels. Within a few months, she was liquidating CDs to pay the bills that never seemed to be a problem with those terrible Ginnie Maes.

Don’t let such uniformed thinking sabotage your retirement program; don’t let the selfish advice of a product sharpshooter send you chasing rabbits when IRE (interest rate expectations) or other temporary market conditions shrink the market value of your income portfolio. Feed your head; feed—your—head.

Income pays the bills, and if the income level is both steady and adequate, there is no need to change investments. Market value should be used to determine when to buy more (at lower prices) and when to take profits (at higher ones). It is almost never necessary to take a loss on a high quality (government guaranteed in Alice’s case) income security.

More recent experimenters in much more sophisticated potions have addressed the issue with similar results, reaching mind-numbing conclusions such as these:

  • I know the income hasn’t changed throughout the debacle in the financial sector but I don’t want to buy anymore of these securities until the prices go back above what I paid for them originally. Translation: I’d rather stick with my 4.5% tax-free yield than increase it by adding to my positions at lower prices.
  • Sure, I understand the relationship between IRE and the prices of income CEFs but individual bonds and Treasuries haven’t suffered nearly as much. That’s where we should have been. Translation: I would be much happier with a 3% than with an 8% rate of realized income.
  • I’m tired of seeing all the negative positions in my portfolio. Let’s keep all the income we receive in money market until we’re back in positive territory. Translation: I’d rather accept 0.5% or so, than reduce my cost basis and increase my yield by adding to my positions at lower prices.

Modern brokerage firm monthly statement “pills” were developed during the dot-com era, when Wall Street was trying to emphasize the brilliance of its speculative prescriptions by making us all feel ten feet tall, month after month after month.

But the geniuses on the institutional chessboard produced too many mushroom product varietals and the Red Queen of corrections lopped off many of their sacred heads. The papers that were designed to make our chests burst with pride have turned on us as a haunting reminder of the reality of markets and the cycles that push them in either direction.

It should be easy to navigate a quality income portfolio through whatever circumstances, cycles, and scandals come at you, but a clear head and a clearer understanding of what to expect is required. Most brokerage firm statements make it difficult to monitor asset allocation using any methodology, including the Working Capital Model, and I don’t think that it’s by chance.

Confusion breeds unhappiness, and unhappiness brings about change, and the masters of the universe encourage you to fritter around from mushroom to mushroom in perpetual motion. To whose benefit?

It would be wonderful if an investor’s monthly statement would organize his securities based on their class and purpose, but Wall Street doesn’t want such distinctions to be made easily. It would be great if the institutions would help investors formulate reasonable expectations about various types of securities under varying conditions, but that’s not likely to happen either.

It would be spectacular if the media would produce information and explanation instead of news bites and sensationalism, but you guessed it — not much chance of that.

Income investing can be easy. Ask your hookah-smoking caterpillar to give you the how?

The “Total Return” Shell Game

No “Interest Rate Sensitive” Security is an Island…

Just what is this “total return” thing that income portfolio managers like to talk about, and that Wall Street uses as the performance hoop that all investment managers have to jump through? Why is it mostly just smoke and mirrors?

Here’s the formula:

  • Total Income + (or -) Change in Market Value – Expenses = Total Return — and this is supposed to be the ultimate test for any investment portfolio, income or equity.

Applied to Fixed Income Investment Portfolios, it is useless nonsense designed to confuse and to annoy investors.

How many of you remember John Q. Retiree? He was that guy with his chest all puffed up one year, bragging about the 12% “Total Return” on his bond portfolio while he secretly wondered why he only had about 3% in actual spending money.

The next year he’s scratching his head wondering how he’s ever going to make ends meet with a total return that’s quickly approaching zero. Do you think he realizes that his actual spending money may be higher? What’s wrong with this thinking? How would the media compare mutual fund managers without it?

Wall Street doesn’t much care because investor’s have been brainwashed into thinking that income investing and equity investing can be measured with the same ruler. They just can’t, and the “total return” ruler itself would be thrown out with a lot of other investment trash if it were more widely understood.

  • If you want to use a ruler that applies equally well to both classes of investment security, you have to change just one piece of the formula and give the new concept a name that focuses in on what certainly is the most important thing about income investing — the actual spending money.

We’ll identify this new way of looking at things as part of “The Working Capital Model” and the new and improved formulae are:

  • For Fixed Income Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!
  • For Equity Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!

Yes, they are the same! The difference is what the investor elects to do with the spending money after it has become available. So if John Q’s Investment pro had taken profits on the bonds held in year one, he could have sent out some bigger income payments and/or taken advantage of the rise in interest rates that happened in year two.

Better for John Q, sure, but the lowered “total return” number could have gotten him fired. What we’ve done is taken those troublesome paper profits and losses out of the equation entirely. “Unrealized” is “un-relevant” in an investment portfolio that is diversified properly and comprised only of investment grade, income producing securities.

Most of you know who Bill Gross is. He’s the fixed Income equivalent of Warren Buffett, and he just happens to manage the world’s largest “open ended” bond mutual fund. How was he investing his own money during other interest rate cycles?

Well, according to an article by Jonathan Fuerbringer in the Money and Business Section of January 11, 2004 New York Times, he’s removed it from the Total Return Mutual Fund he manages and moved it into: Closed End Municipal Bond Funds where he could “realize” 7.0% tax free.

(Must have read “The Brainwashing of the American Investor”.)

He doesn’t mention the taxable variety of Closed End Fund (CEF), now yielding a point or two more than the tax free variety, but they certainly demand a presence in the income security bucket of tax-qualified portfolios (IRAs, 401k(s), etc.).

Similarly, the article explains, Mr. Gross advises against the use of the non investment grade securities (junk bonds, for example) that many open-end bond fund managers are sneaking into their portfolios.

But true to form, and forgive the blasphemy if you will, Mr. Gross is as “Total Return” Brainwashed as the rest of the Wall Street institutional community — totally. He is still giving lip service validity to speculations in commodity futures, foreign currencies, derivatives, and TIPS (Treasury Inflation Protected Securities).

TIPs may be “safer”, but the yields are far too dismal. Inflation is a measure of total buying power, and the only sure way to beat it is with higher income levels, not lower ones. If TIPS rise to 5%, REITS will yield 12%, and preferred stocks 9%, etc.

No interest rate sensitive security is an Island!

As long as the financial community remains mesmerized with their “total return” statistical shell game, investors will be the losers.

  • Total Return goes down when yields on individual securities go up, and vice versa. This is a good thing.
  • Total Return analysis is used to engineer switching decisions between fixed income and equity investment allocations, simply on the basis of statements such as: “The total return on equities is likely to be greater than that on income securities during this period of rising interest rates.”

You have to both understand and commit to the premise that the primary purpose of income securities is income production. You have to focus on the “Income Received” number on your monthly statement and ignore the others… especially NAV.

If you don’t agree with the next three sentences; if they don’t make complete sense: you need to learn more about Income Investing:

  • Higher interest rates are the income investor’s best friend. They produce higher levels of spending money.
  • Lower interest rates are the income investor’s best friend. They provide the opportunity to add realized capital gains to both the total spending money and total working capital numbers.
  • Changes in the market value of investment grade income securities, Yogi says, are totally and completely irrelevant, 97% of the time.

Wall Street’s Dirtiest Little Secret

As of Close of Business May 8th, no less than 53 multi-year experienced, Tax Free Income, Closed End Funds (CEFs) were paying 6% or more in federally tax free income to their shareholders.

18 issues (34%) paid 6.4% or above, and the average for the group was 6.35%. All portfolios are professionally managed by this dozen, well respected, long experienced investment companies.

Blackrock, Nuveen, Pimco. Putnam, Invesco, Alliance-Bernstein, MFS, Dreyfus, Eaton Vance, Deutsche, Pioneer, & Delaware Investors.

How difficult could it be to put together a well diversified, retirement income portfolio?

Most of these funds have paid steady, dependable, income for more than fifteen years, even through the financial crisis… several have been around since the ’90s

Yet your financial advisor has never mentioned them to you; you have never heard them advertised or reviewed in the financial press… Wall Street, it seems, would prefer that you didn’t know they exist.

But there’s even more to this story. These readily-available and much-higher-than-you’ve-been-led-to-believe-even-exist tax free yields can be purchased at bold discounts to their Net Asset Value, or NAV in Mutual Fund Terms.

A May 15th data search at cefconnect.com reveals that 85% of all Municipal Bond Closed End Funds (CEFs) were selling below their net asset values (NAVs), and of those, 20% were available to all investors at discounts above 10%.

Mutual Funds (I believe) are never available at discounts from NAV, and how many discounted munis has your advisor suggested to you since 2012 or earlier?

Municipal CEFs regularly sell at discounts, and this morning, nearly 60% were available to MCIM taxable account investors at discounts of 5% or more.

WHY THE WALL STREET COVER-UP?

Why aren’t you asking for more information?

How To Be Prepared for Rising Interest Rates

I’ve seen a lot of discussions lately that erroneously conclude: “rising interest rates are something to be feared and prepared for” by buying short duration bonds or by liquidating income purpose securities entirely. Have they all gone mad!

A rising interest rate environment is super good news for investors… up to a point. When we loan money to someone, is it better to get the lowest possible rate for the shortest period of time? Stop looking at income investing with a “grow the market value” perspective. That’s not what it’s all about.

The purpose of income investments is the generation of income, and that goes for all forms of bonds, preferreds, government securities, etc. Control the quality selected, diversify properly, and compound that part of the income that you don’t have to spend. Bond prices are pretty much irrelevant since you spend the income and not the  market value.

Long, long, ago, many bonds were of the “bearer” variety; my father never owned any others. Each month, he went to the bank, clipped his coupons, cashed them in, and left the bank with a broad smile. If interest rates went up, he knew he could go out and buy new bonds to put larger coupon dollars in his pocket.

He had no reason to even consider selling the bonds he held — they were, after all, income purpose securities that had never failed to do their job. Market value never fluctuates (visually) if the securities are kept in the (mental) safe deposit box.

No, this is not at all what I’m suggesting to you as an investment… this is a mindset you need to embrace to become a successful income investor.

Even when your statement shows bond prices at chest-pounding wealth levels, the income generated hasn’t changed. And the profits your statement reports… really just another Wall Street illusion.

The thing dear old Dad thought about least was the market value of his bonds. This was his tax free retirement plan (one way or the other). He bought them for income, and the coupons were always redeemed without question. The only problem with the periodic decreases in market value was the inability to add to existing positions.

Before I move on to the simple solution to this non-problem, a word or two on the only real benefit of lower interest rates — there is none if you don’t already own individual, income producing, securities. If you own interest rate expectation (IRE) sensitive securities in a downward interest rate cycle, you will have the opportunity for what I call “income-bucket-gravy”.

This is the opportunity to sell your income purpose securities at a profit, over and above the income you’ve already banked. Income investors rarely are advised to do this, which is why they lament the thievery of higher rates. They didn’t sell at a premium, and now “actionlessly” watch the profits disappear.

This behavior achieves the lowest possible yields while pushing scared-silly investors into an overpriced market for short duration debt… the ultimate Wall Street “markup” machine, where brokers literally make more than bondholders.

The solution is simple, and has been used successfully for decades. Closed End Funds (scoff, laugh, and say “leverage makes them volatile” all you like) solve all the liquidity and price change problems… in a low cost, much higher income, environment.

Read that again, and again, until you get mad at your advisor.

Answer this question before you throw stones. Is 7% or more on a diversified, transparent, income portfolio, compounded over the past ten years and still growing income, better or worse than the 3.5% or less that most investors have realized in individual securities during the same time period… and then there are the profits that you never realized you could realize so effectively.

Of course CEF market values fell during the financial crisis, but at their peak in November 2012, they had gained nearly 18% per year since 3/9/09…. nearly outperforming the S & P 500. But speaking of “drawdowns”, what do you think the economic activity drawdown of near zero money market rates has been, particularly for “savings account” Baby Boomers.

Did the Fed’s messing around with short term interest rates help or hurt your retired relatives… really, think about it.

Rising interest rates are good for investors; so are falling rates. Fortunately, they routinely move in both directions. They can be traded quickly for exceptional results from “stodgy” income CEF portfolios.

So much for Total Return, short duration, and leverage-phobic thinking.

What if you could buy professionally managed income security portfolios, with 10+ years income-productive track records? What if you could take profits on these portfolios, for a year’s interest in advance, and reinvest in similar portfolios at higher yields? What if you could add to your positions when prices fall, increasing yield and reducing cost basis in one fell swoop?

What if you could prepare for retirement with such a powerful income engine?

Well, you ca do all four. but only if you add both higher and lower interest rates to you list of VBFs.

Can’t attend the next Income investing Webinar? Contact Steve Selengut for a FREE video.

Why so much ado about interest rates?

Mal Spooner
Mal Spooner

Why the popularity of shorter-term interest-bearing securities among Canadians, in particular GIC investments?  In fact, we in Canada are not the only investors who seem satisfied investing our money knowing that the rate-of-return might just barely cover the rate of price inflation, with a significant risk of actually losing money if inflation should rise even modestly.  And it is not just people who are content with the arrangement between ourselves and the borrowers of our money – banks, insurance companies and credit unions alike – corporations have been hoarding cash since the Financial Crisis too.

This past summer, Statistics Canada reminded us that corporations in Canada continued to grow their cash hoard rather than invest the funds in their businesses.  Of course, like people, companies don’t actually hold cash, but rather invest the money in low risk short-term interest bearing securities, often in Government of Canada T-bills and bonds, as well as commercial paper offered by financial institutions.

At the end of the second quarter of 2008, corporations held $373.4 billion in cash balances (Statistics Canada November 17th, 2009 study: Indebtedness and liquidity of non-financial corporations).  By the first quarter of this (2014) year the number had grown to a whopping $629.7-billion. So why the stubborn tendency to tolerate a near-zero rate-of-return?

There are at least two factors at work in my estimation.  One has to do with the economics of interest rates in the current environment, another with human nature and demographics.

First of all, what is an interest rate?  It embodies three important expectations-related factors: Real returns, inflation and risk.  We all are reluctant to part with our cash unless we’re able to earn what economists call a ‘real’ return.  Ask yourself, what rate-of-return would make you happy if there was essentially no risk (default, volatility) to speak of and no price inflation.  Whatever you buy today, will in theory cost you the same price next year and every year after that.  Most agree that the very long-term real rate of interest is somewhere between 2% and 4%.  Real Rates Canada 2004 to 2014However, you can easily see from the graph that the real rate of return provided by Government of Canada (as low risk as you can find) long-term real return bonds over the past ten years has been driven down since the Financial Crisis, as all governmental central banks strove to fight disinflation by dampening the general level of interest rates.

Has the return we expect from lending our funds really adjusted downward, or is it that the availability of securities providing the returns we normally demand has changed?  My guess is most folks would agree that the adage ‘once burned, twice shy’ aptly summarizes our tendency to be  biased by recent experience.  It is human nature to be sensitive to bad or good things that have just happened and to oftentimes unreasonably expect them to continue.  Also, we are confronted by a lack of options.  Securities available to us are not promising the rates-of-return we want, given the amount of risk we are prepared to stomach.

In fact, a quick look at one of many high-dividend oriented ETF’s, the iShares Core S&P/TSX Composite High Dividend Index ETF suggests that a collection of dividend paying stocks yielded 4.31% (as of October 2, 2014) over the past (trailing) 12 months.  As a bonus, the tax treatment of dividends is more generous than it is for interest income.  Indeed the stock market has done perhaps too well over the last few years, but judging by the massive dollars invested in short-term securities those equity returns have not been earned by everyday people. The issue is people just don’t seem to want the volatility that comes with investing in stocks; even when the selection of stocks is less risky than the overall stock market.  A real return with some risk is less attractive than no return at all, and it has been like this for quite awhile now. The second ingredient to interest rate levels is inflation expectations.

Source: Bank of Canada
Source: Bank of Canada

Admittedly, we haven’t seen a whole bunch of price inflation have we?  Central bank policy around the world has been more interested in creating some inflation, fearing that disinflation would prove devastating to our economic welfare.  These efforts are in fact evidenced by the historically low level of administered interest rates we have.  If our collective expectations concerning future price inflation are significantly different from what we are experiencing then our behaviour will reflect it. Could it be that the extraordinarily high commitment to GIC’s and equivalents is that Canadians, and Americans are doing it too, are content to simply keep their money (even at the risk of a small loss) intact until rates of inflation and returns get back to levels they think they can believe in?

The third important determinant of interest rate levels is our toleration for risk, and it exists in many different forms.  Our appreciation for the risk of default was certainly modified during the Financial Crisis; and in short order we’ve been willing to tolerate none of it.  We’ve turned a blind eye to significant stock market appreciation and even bond returns preferring to ‘check’ rather than ‘raise’ and ‘all in’ has certainly been out of the question.   But this intolerance to take risk has become very sticky at the individual level and at the corporate level.  This might have more to do with demographics than anything else.

Younger people are quite surprised to learn that real interest rates got as high as 6% – 9% during the mid-1980’s, and during the 90’s and up to the turn of the millennium ranged around the 4% level. (Source: I was there!)  There is a large proportion Canadians who lived through those times.  According to Statistics Canada there is roughly an equal number of young people as there are older people.  Ratio of old to young in CanadaHalf of us in Canada might consider those times ancient history (or have no interest at all in history), and the other half feel as if it was just yesterday that mortgage rates were in the double digits.

These more seasoned citizens look at the rates of return offered by the bond market and similar investment vehicles and say to themselves: “Hey, if I buy a longer term bond, I’m earning next to nothing anyway, so I’ll just put money into shorter term GIC’s and term deposits that are effectively earning nothing and avoid the risk of having my money tied up.”  Having experienced periods of rising inflation and higher real rates, they (and yes, I’m a member of that distinguished group) are inclined to wait until more generous returns come back – if they ever do come back.  And don’t forget, these same folks might actually have to spend their savings sooner rather than later suggesting that any risk of a big loss in the stock or bond market is simply untenable.

Most people when they think of Canada bonds, immediately think of Canada Savings Bonds.  They are not the same at all.  Normal Government of Canada bonds, held in mutual funds and pension plans for example, rise and fall in value as interest rates change.  Although we’ve been through a very long stretch of falling interest rates, which made bond prices steadily go up in value, there have been and will be periods when interest rates rise and people lose money in bonds.  It is smart to learn how the time value of money works and how and why bonds can make or lose money.  There is a plethora of online videos that can help you understand bond valuation and the investment in your time to learn bond dynamics is well worth the minimal effort.

The yield curve is simply a plot of interest rates corresponding to varying maturities at a point in time.  Ordinarily, we expect to earn higher returns the longer our money is lent to someone else.  GIC rates are lower when the hold period is 3 months than they are when your money is tied up for 3 years.  The same should be true for bonds.  But consider where we’ve come from:  US Treasury Dept. Yield CurvesThe graph shows the yield curves for US Treasury bonds as of October 2007 compared to the same today.  The 2007 yield curve reflects the uncertainty at that time about, well almost everything.  We didn’t know if we should accept lower rates for shorter investments or high rates for longer term bonds so the curve was somewhat flattish.  What would inflation be?  Which financial institution would be solvent?  Would the US government even be solvent?  Many questions but few answers in the midst of the financial turmoil.

The more current yield curve reflects today’s reality.  The only interest rates we can earn in the short-term are hovering close to zero, and since longer-term risk-free bonds are paying us barely one percent over inflation why assume the added risk.  If interest rates do rise from these low levels, then you will certainly lose money owning the longer-term bonds.

In a nutshell, people have doing what they should be doing – seeking shelter and waiting it out.   A side-effect of this behaviour is that our willingness to tolerate no return for lots of safety has stalled the return to financial market normality.  By stubbornly remaining in GIC’s, term deposits and money market funds we are inadvertently delaying what we desire – a decent return for taking some risk.  It’s only when money moves freely and to a large extent greedily that financial markets function properly.  This presents quite a conundrum for policy makers around the world, who’ve been praying that businesses invest in business instead of hoarding their cash, and people begin spending more and taking on more risk by investing their savings in more diverse ways.

There are many pundits who have suddenly jumped on the bandwagon predicting a stock market meltdown and impending bond market rout.  If they are right and this happens then we might finally get what we want after-the-fact; returns that compensate us fairly for inflation and risk.  In fact the stock market is suffering of late, and a shift (or rather, twist)  in the yield curve is already causing some havoc for bond managers.  The longer-term rates have declined rather than risen as expected, and mid-term bond yields have surprisingly risen – causing grief even for gurus like Bill Gross, who co-founded PIMCO and until recently managed one of the world’s largest bond portfolios.

If investors have been doing the right thing to feel secure, what should they be doing next?  Over my own lengthy career I’ve found that at some point it is important to combat inertia and begin moving in a different strategic direction.  As stock prices adjust downwards, take advantage of what happens.  The dividends paid on the increasingly lower stock prices become more attractive quickly, and remember they are taxed at preferential rates.  The world economy may continue to grow at only a snail’s pace, so why not test the waters so to speak and begin putting some funds into longer-term interest-earning bonds.  If inflation does creep up and interest rates increase some, then put even more funds to work at the higher yields.    Having done the safe thing during turbulent times, perhaps it’s time to do the smart thing.  Experience teaches us that the best time to be doing the smart thing is almost always when it is most difficult to do it.  The longer you earn nothing, the poorer you get.

 

Total Return: Smoke and Mirrors?

Just what is this “total return” hoop that investment managers are required to jump through? Why is it mostly just smoke and mirrors? Here’s the formula:

  • Total Income + (or -) Change in Market Value – Expenses = Total Return — the ultimate test for any investment portfolio.

Applied to income purpose portfolios, it is really close to nonsense, and confusing to most investors.

Remember John Q. Retiree? He was the guy with his chest all puffed up one year, bragging about the 12% “Total Return” on his bond portfolio. Secretly, he wondered about having only 3% in actual spending money.

A year or so later, he’s scratching his head wondering how he’s going to make ends meet with a total return that’s approaching zero. Do you think he realizes that his spending money may be higher?

What’s wrong with this thinking? How will the media compare mutual fund managers without it?

Wall Street doesn’t much care. They set the rules and define the performance rulers, and they say that income and equity investment performance can be measured with the same tools. They can’t, because their investment purposes are different.

If you want to use a ruler that applies equally well to both classes of security, just change one piece of the formula and give the new math a name that focuses on the actual purpose of income investing — the spending money.

We found this old way of looking at things within “The Working Capital Model”; the new and improved formulae are:

  • For Fixed Income Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!
  • For Equity Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!

Yes, they are the same, and divided by the amount invested, they produce a Total Realized Return number. The difference is what the investor elects to do with the spending money.

So if John Q had taken profits in year one, he could have spent more, or added to his income production. You just can’t spend (or reinvest) “Total Return”.

We’ve taken those troublesome paper profits and losses out of the equation entirely. “Unrealized” is “un-relevant” in a properly diversified portfolio comprised only of investment grade, income producing securities.

Most of you know of Bill Gross, the Fixed Income equivalent of Warren Buffett. He manages a humungous bond mutual fund, but how does he invest his own money?

According to a NYT Money and Business article by Jonathan Fuerbringer (January 11, 2004), he’s “out” of his  own Total Return fund and “in” Closed End Muni Funds paying 7.0% tax free. (Must have read “The Brainwashing of the American Investor”.)

Fuerbringer doesn’t mention the taxable variety of CEF, then yielding roughly 9%, but they certainly demand a presence in the income security bucket of tax-qualified portfolios like 401ks. Sorry, can’t do that now. The omniscient DOL says the net/net income isn’t nearly as important as the Expense Ratio….

Similarly, Mr. Gross advises against the use of the non investment grade securities (junk bonds, etc.) that many fund managers  sneak into their portfolios.

But true to form, Mr. Gross is as “Total Return” Brainwashed as the rest of the Wall Street institutional community, as he gives lip service validity to speculations in commodity futures, foreign currencies, derivatives, and TIPS.

Inflation impacts buying  power, and the only way to beat it is with higher safe income. If TIPS rise to 5%, REITS will yield 12%, and preferred stocks 9%, etc. No interest rate sensitive security is an Island!

As long as financial intellectuals remain mesmerized with total return numbers, investors will be the losers.

  • Total Return goes down when yields on individual securities go up, and vice versa. This is a good thing.
  • Total Return analysis is used to engineer market timing decisions between fixed income and equity investments, based on statements such as: “The total return on equities is likely to be greater than that on income securities during this period of rising interest rates.”

Investors have to commit to the premise that the primary purpose of income securities is income production… this requires a focus on spending money.

If these three sentences don’t make complete sense to you, you need to learn more about income purpose investing:

  • Higher interest rates are the income investor’s best friend. They produce higher levels of spending money.
  • Lower interest rates are the income investor’s best friend. They provide the opportunity to add realized capital gains to total spending money and to total working capital.
  • Changes in the market value of investment grade income securities are totally and completely irrelevant, 99% of the time.

The Extremely Good News About Higher Interest Rates

What!

Yes, market values of existing income purpose securities will certainly move lower… BUT, the income you’ve contracted for will likely remain the same, AND, you will be able to invest in new paper at higher yields.

This is a good thing, and you should not be so easily convinced that it is not. Even if your “guaranteed” paper falls in price, there need never be a loss of “principal”.

If I’m borrowing money, higher rates are bad news; for investors, higher rates mean more spending money while lower market values just mean lower market values.

The purpose of income securities is income, and a reasonably safe “more” has always been better than any “less”. The problem is simply the negative perception of a lower portfolio “total market value”. OMG!

In our financial lives, what we can spend or reinvest is the important detail, and when dealing with income-purpose investments, 99% of the time, change in market value has no impact on income received.

This was most clearly demonstrated during the financial crisis:

More than 90% of borrowers remained current on their mortgages, yet all mortgage backed securities were deemed nearly valueless under absurd “mark to market” regulations.

Even with monthly payments pouring in, many financial institutions failed to meet regulatory “market value” reserve requirements and were forced to close their doors.

At the same time, even at lower market values, virtually all non-mortgage securities, particularly managed Closed End Funds, continued to pay the same levels of interest like clockwork, while a “clockwork orange-esque” nightmare played out in financial institutions.

This focus on market value is a financially inappropriate attempt to equate the nature of debt securities to that of equities… one that could never, ever, have happened without multiple levels of ill conceived and misguided regulation.

It’s like time, tide, and gravity; you just don’t mess with Mother Nature. Price varies inversely with interest rate expectations, and this is a good thing… end of discussion.

By using Closed End Income Funds, investors can benefit from lower rates on older holdings, even as market values tumble… and this should be exciting , not scary at all.

Buying additional shares of existing bond portfolios at lower prices. Eureka!

As Yogi would say, 95% of income investing is half mental.

LinkedIn financial group members debate the impact of higher interest rates… but to income investors, there should be no debate at all. Both higher and lower rates are good for investors.

Here’s an example of where this is coming from.

I’m intimately familiar with many closed end income funds, diversified in every conceivable way, over 100 issues, with varying durations, etc. The “purpose” of the funds is twofold: (1) grow the income generated by the portfolio, while at the same time (2) distributing what individuals need to pay their monthly bills.

Income CEFs (both tax free and taxable) moved down in market value during the financial crisis, back up again (at a faster pace than stocks, actually) through November 2012, down again through the end of 2013, and now up again at a pace about the same as the S & P 500, or a bit better, through May.

During this seven years of market value direction change and short term volatility, there has been: (1) an upward move in total portfolio income, due to reinvestment of excess income; (2) never an instance of dipping into principal for a properly planned payment; (3) and hundreds of opportunities for “one-year’s-interest-in-advance” profit taking.

During seven years of historically low interest rates, income Closed End Funds have produced multiples more spending money than any other comparably safe source of income…. taxable funds are in the 7% range (net of fund expenses including interest) right now.

What negative impact has the change in market value had on the monthly income produced for Closed End Fund Investors throughout the past seven years? A resounding… NONE!

What positive impacts? Growth in income produced, growth in portfolio yield, and growth in “Working Capital” (the amount invested in the total portfolio), and not only in the income “bucket” when cost-based asset allocation is used.

Meanwhile, how have investors fared in shorter duration, stable value paper? What’s better for the economy, retirees receiving 6% tax free or less than 2%, taxable?

When investing for income, go long, emphasize experience and quality, diversify properly, and focus ( I mean really focus) only on the income you receive.

Ask your advisor:  Why is 2% better than 7%?

Wither Interest Rates

Knut Wicksell had quite a lot to say about how interest rates work. He was born in 1851, died in 1926 and was an economist who influenced both the Austrians Hayek and Von Mises and at the same time Keynes. He is a resource in at least six economic schools of thought. Clearly a useful thinker.

He might be able to tell us a little about the current interest rate situation. Why do near-zero rates fail to stimulate the economy as much as our politicians expect?

In economics there is a concept of the “Market Clearing Price.” The price at which all of the production will be sold and all of the people who wish to buy a product are able to do so. If there is too much production, the price falls until it is sold. If there is too little, the price rises until demand matches.

Interest rates are the price for money, so why is there so little demand for the product when the price is so low?

Wicksell proposed that there are two interest rates. The “Natural Rate” which is the rate that arises based upon the expectation that people can profit in the future as the result of borrowing at the rate. There is another rate, the “Financial Rate” which is what lenders actually charge.

Wicksell believed that if the financial rate was less than the natural rate, then people would borrow almost infinitely to take advantage. They compare their price to the natural rate – the fair price for the opportunity to earn in the future and see a bargain.

Why is there no investment today given that in some cases the guaranteed financial interest is near zero?

The answer is just common sense. Because the natural rate today may be even lower than zero. There is little demand for the money because if you borrow money, at any price, even zero percent, you have to pay back the interest and the principal. To pay them back, you need to know that:

  • in a business or an investment situation, what you invest the borrowing into will supply sufficient income to pay the loan off in the required time, or
  • in a personal situation that your future take home income will be enough to make the necessary payments.

Today we find that many people do not as yet have the confidence in either of these two conditions to undertake significant obligations. It is not the interest rate that is troubling, it is the principal payment that is troubling.

If you could borrow at 0% interest and had to pay back only 90% of the principal, would you borrow? Some people would say no today. How about 75% of the principal?

We find that the market clearing price for money is irrelevant as long as lenders want the capital back. A 0% loan is not attractive if you cannot see how to pay the principal.

Clearly the policy approach is to pay less attention to the price of money and more attention to economic expectations.

Business people, and I suppose everyone else, are avoiders of uncertainty, so the solution for the policy folks is reduce the uncertainty. Have a clear economic path that government follows. Avoid trivial regulation. Do not disparage those who invest and profit. Promote reality instead of illusions like having a degree provides you with a great living. Keep your word. Be transparent. Give indications of proposed changes in direction.

The best incentive to economic growth is removing disincentives to economic growth and personal prosperity. Without that there will be no price that induces people to borrow or invest. At least not here.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.