Is Your Investment Portfolio Prepared For Higher Interest Rates?

I’ve heard a lot of discussion lately pressing the idea that rising interest rates are something to be feared, and prepared for by: accepting the lower rates now, buying the shortest duration positions, or even liquidating the income portfolio entirely.

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. Lower market values or growing discounts to NAV don’t have to be problems… they can be benefits.

The purpose of income investments is the generation of income. YOU are NOT a bond trader. Control the quality selected, diversify properly, and compound that part of the income that you don’t have to spend. Price is pretty much irrelevant with income purpose securities; you don’t spend 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 already owned — they were, after all, income purpose securities that (in his experience) never failed to do their job. Market value never fluctuates (visually) if the securities are kept in the (mental) safe deposit box.

No, that’s not at all what I’m recommending… And, even when your brokerage statement shows that your bond prices have risen to chest-pounding wealth levels, just try to convert those numbers into spending money. Despite the profit-taking-temptation your statement reports, the bid you get on your smallish positions is never even close to the “insider” market value…

The thing dear old Dad thought about least was the market value of his bonds. This was his tax free retirement plan. He bought them for income, and the coupons were always redeemed without question. The only problem (actually, no longer a problem) with the periodic decreases in market value was the inability to add to existing positions. The small position bond market has limited liquidity.

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 no benefit at all 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 occasioned by higher interest rates. They didn’t sell at a premium, so now they just sit and watch the premiums disappear.

The only thing this behavior accomplishes is bestowing on investors the lowest possible yields while pushing them into an overpriced market for short duration debt securities. A gift that keeps on stealing investor profits.

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.

Answer me one question before you throw stones at these remarks. 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 non-bond traders seldom realize can be realized.

Of course CEF market values fell during the financial crisis (the 3nd greatest buying opportunity ever), but at their peak in November 2012, they had gained nearly 65% since March 9, 2009, or 17.7% per year…. 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, cyclically, and now can be traded quickly and inexpensively for exceptional results from a stodgy old income portfolio. 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, say for a year’s interest in advance, and reinvest in similar portfolios at higher yields?
  • What if you could add to your positions in all forms of debt securities when prices fall, thus increasing yield and reducing cost basis in one fell swoop?
  • What if you could enter retirement (or prepare for retirement) with such a powerful income engine?

Well, you can. but only if you are able to add both higher and lower interest rates to you list of VBFs.

The Investment Gods Are Furious

Market Cycle Investment Management (MCIM) is an historically new methodology, but with roots deeply embedded in both the building blocks of capitalism, and financial psychology— if there is such a thing.

The earliest forms of capitalism sprung from ancient mercantilism, which involved the production of goods and their distribution to people or countries mostly around the Mediterranean.

The sole purpose of the exercise was profit and the most successful traders quickly produced more profits than they needed for their own consumption. The excess cash needed a home, and a wide variety of early entrepreneurial types were quick to propose ventures for the rudimentary rich to consider.

There were no income taxes, and governments actually supported commercial activities, recognizing how good it was for “Main Street” — as if there was such a thing.

The investment gods saw this developing enterprise and thought it good. They suggested to the early merchants, and governments that they could “spread the wealth around” by: selling ownership interests in their growing enterprises, and by borrowing money to finance expansion and new ventures.

A financial industry grew up around the early entrepreneurs, providing insurances, brokerage, and other banking services. Economic growth created the need for a trained workforce, and companies competed for the most skilled. Eventually, even the employees could afford (even demand) a piece of the action.

Was this the beginning of modern liberalism? Not! The investment gods had created the building blocks of capitalism: stocks and bonds, profits and income. Stock owners participated in the success of growing enterprises; bondholders received interest for the use of their money; more and better skilled workers were needed — the K.I.S.S. principle was born.

As capitalism took hold, entrepreneurs flourished, ingenuity and creativity were rewarded, jobs were created, civilizations blossomed, and living standards improved throughout the world. Global markets evolved that allowed investors anywhere to provide capital to industrial users everywhere, and to trade their ownership interests electronically.

But on the dark side, without even knowing it, Main Street self-directors participated in a thunderous explosion of new financial products and quasi-legal derivatives that so confused the investment gods that they had to holler “’nuff”! Where are our sacred stocks and bonds? Financial chaos ensued.

The Working Capital Model was developed in the 1970s, as the guts of an investment management approach that embraced the cyclical vagaries of markets. This at a time when there were no IRA or 401(k) plans, no index or sector funds, no CDOs or credit swaps, and very few risky products for investors to untangle.

Those who invested then: obtained investment ideas from people who knew stocks and bonds, had pensions protected by risk-averse trustees, and appreciated the power of compound interest. Insurance and annuities were fixed, financial institutions were separated to avoid conflicts of interest, and there were as many economics majors as lawyers in Washington.

MCIM was revolutionary then in its break from the ancient buy-and-hold, in its staunch insistence on Quality, Diversification, and Income selection principles, and in its cost based allocation and diversification disciplines. It is revolutionary still as it butts heads with a Wall Street that has gone MPT mad with product creation, value obfuscation, and short-term performance evaluation.

Investing is a long-term process that involves goal setting and portfolio building. It demands patience, and an understanding of the cycles that create and confuse its landscape. MCIM thrives upon the nature of markets while Wall Street ignores it. Working Capital numbers are used for short-term controls and directional guidance; peak-to-peak analysis keeps performance expectations in perspective.

In the early 70s, investment professionals compared their equity performance cyclically with the S & P 500 from one significant market peak to the next — from the 1,500 achieved in November 1999 to the 1,527 of November 2007, for example. Equity portfolio managers would be expected to do at least as well over the same time period, after all expenses.

Another popular hoop for investment managers of that era to jump through was Peak to Trough performance —managers would be expected to do less poorly than the averages during corrections.

Professional income portfolio managers were expected to produce secure and increasing streams of spendable income, regardless. Compounded earnings and/or secure cash flow were all that was required. Apples were not compared with oranges.

Today’s obsession with short-term blinks of the investment eye is Wall Street’s attempt to take the market cycle out of the performance picture. Similarly, total return hocus-pocus places artificial significance on bond market values while it obscures the importance of the income produced.

MCIM users and practitioners will have none of it; the investment gods are furious.

Market Cycle Investment Management embraces the fundamental building blocks of capitalism — individual stocks and bonds and managed income CEFs in which the actual holdings are clearly visible. Profits and income rule.

Think about it, in an MCIM world, there would be no CDOs or multi-level mortgage mystery meat; no hedge funds, naked short sellers, or managed options programs; no mark-to-market lunacy, Bernie Madoffs, or taxes on investment income.

In MCIM portfolios, lower stock prices are seen as a cyclical fact of life, an opportunity to add to positions at lower prices. There is no panic selling in high quality holdings, and no flight to 1% Treasuries from 6% tax free Munis. In an MCIM portfolio, dividends and income keep rolling, providing income for retirees, college kids, and golf trips — regardless of what the security market values are doing.

Capitalism is not broken; it’s just been overly tinkered with. The financial system is in serious trouble, however, and needs to get back to its roots and to those building blocks that the Wizards have cloaked in obscurity.

Let’s stick with stocks and bonds; lets focus on income where the purpose is income; let’s analyze performance relative to cycles as opposed to phases of the moon; let’s tax consumption instead of income; and let’s not disrespect the gods, the “Bing”, or the intelligence of the average investor…

So sayeth the gods. Amen!

Lower gas prices can mean really big TFSA savings!

Many Canadians have grown accustomed to low mortgage rates and strong residential pricing, and now the price of gasoline is leaving a few more bucks in our pockets.  Don’t get too comfortable, because history teaches us that none of this is sustainable.  It is circumstances like the present that make seasoned money managers anxious.  While neophytes are happy to carelessly bathe in the sunshine, experts are usually getting ready for the next storm.  What can you do?  With lower gasoline prices providing some extra cash flow why not use the cash to bolster your savings?

One cloud on the horizon has been getting some attention of late.  The massive global financial stimulus that has caused interest rates to remain low for so long has had a predictable impact on our collective behaviour.  Canadians have borrowed money like there’s no tomorrow.

Household Debt vs Disponable IncomeAccording to data from Statistics Canada, our total borrowing has been on a steady incline since 1990, while servicing the debt has been eating away at our disposable income.  Sure, we tightened our belts some during the financial crisis, but the temptation to borrow at low rates has just been too much to overcome.

It is difficult to save money, when so little of one’s income is disposable.  And most financial advisers would recommend that it doesn’t make a whole bunch of sense to save money at all when you owe money.  It makes far more financial sense to pay down your debt.  Based on numbers alone, this is sound advice.  But our behaviour is seldom governed by numbers alone – we are indeed a complex species.

For example, contributing to your RRSP provides a tax savings in the same year your contribute right?  So where does it go?  A strictly numbers analysis espousing the merits of RRSPs would certainly factor in those savings to illustrate how effective they are at growing your wealth, but I am inclined to agree with the Wealthy Barber (David Chilton) who frequently points out (and I am paraphrasing here) that those dollars you supposedly ‘saved’ were most probably squandered, not saved.  If the tax savings were indeed invested, then it is true that one’s net worth might grow.  However the iPhone, piece of furniture or other consumer good bought with that tax refund hardly qualifies as savings now does it?

Does it make any sense at all to save when wallowing in debt?  I would argue most emphatically YES!  According to an IPSOS Reid poll published in October:  “The average working Canadian believes they would need $45,609 in savings to sustain themselves for a year should they be off work due to illness.”  Where would this money come from?  In real life, a portion of it would be required for food and lodging yet some of it will be needed just to pay the mortgage or rent.  I’d bet that the average Canadian polled would no doubt have seriously underestimated the amount needed to live on while not working (for whatever reason).  In the same poll roughly 68% admitted to having some or lots of debt – suggesting that 1/3rd of Canadians have none?  Pardon me if I suspect that a good percentage of those polled might also have been too embarrassed to answer candidly even if their responses remained anonymous – we are Canadians after all and loathe to taint our conservative image.

Now is an ideal time to bump up your savings!

Where will the extra cash come from to begin a more aggressive savings program?  Let’s start at the gas pump.  We all feel a bit of relief simply watching the price of gasoline come down when fueling, but has anyone really considered how much they might now be pocketing because of lower energy prices?  In April of 2014 Canadians were paying a near-record $1.50 per litre.  Just 6 months ago the price of gasoline in Toronto was 139.9 cents a litre and today (I am writing this on December 10) it is 103.9 cents.  That’s a whopping 25% decrease.  Say a motorist was spending $50 in after-tax dollars a week.  If they price of gas simply stays at 103.9 the cost savings are $12.50 a week which is equivalent to $650 of annual savings requiring about $1000 of your pre-tax income.  If there is more than one vehicle in a family? Let’s keep it simple and assume $1000 in annual family savings simply from the lower gasoline price.  Never mind that other energy costs (heating) and transportation costs (flights) will also create savings.  What if you simply invested that amount every year and earned a rate of return on it?  It will grow to a handsome sum.  Unfortunately, you will have to pay taxes on those returns but more about that later.

Growth in $1000 annually


Of course it’s unreasonable to expect gas prices to remain at these levels or fall lower.  It is also not wise to anticipate more generous rates of return.  In point of fact, it is foolhardy to expect or anticipate anything at all.  Returns will be what they will be, and gas prices are determined by market forces that the experts have trouble understanding.

Does the uncertainty we must live with mean that savings might just as well be spent on the fly?  As I tell students studying to be financial planners; one must start somewhere and there are two things worth acknowledging up front:

1)  The power of compounding (letting money earn money by investing it) is very real, as evidenced by the table.

2)  It makes sense to have a cushion in the event of a loss of income, the desire to pay down some debt, make a purchase or just retire.

Yes it makes more financial sense to have no debt at all, but the majority of Canadians will borrow for those things they want now rather than later, like a home or car.  If you must borrow, why not save as well?  Fortunately we have been gifted the perfect savings vehicle.  The Tax Free Savings Account introduced in 2009 has advantages that make it an ideal place to park money you are saving at the gas pump.  The returns you earn in the account are tax-free.  With GIC rates as low as they are, you might be inclined to say ‘so big deal?’ But any financial adviser over 45 years of age (I admit, there aren’t many) can tell you that low interest rates are temporary, and besides you can and will earn better returns over the longer term in equity mutual funds just as an example.

TFSA Contribution LimitsOf course there are limits (see table) to what you are allowed to contribute, but best of all they are cumulative.  In other words, if you haven’t contributed your limit since 2009, you can ‘catch up’ at any time.  Including 2014, you have a right to have put up to $31,000 into the account.   Also the contribution limit rises (is indexed) over time with the rate of inflation.  Perhaps most important, you can withdraw money from the account tax-free.  Your contributions were already taxed (there’s no tax deduction when contributing like when you put funds into an RRSP), and the investment returns are all yours to keep.  Using your TFSA means that won’t have to pay those taxes and the effects of compounding aren’t diminished.  To top it off, you are allowed to replace any money you’ve withdrawn in following years.

The seasoned money manager will want some flexibility in the event that he is blindsided.  With your TFSA savings you too will enjoy more flexibility.  If interest rates are higher when you renegotiate your mortgage, taking money out of your TFSA to reduce the principal amount might help reduce your monthly payments to affordable levels.  Should the economy take a turn for the worse over the next several years and you lose your job, then you’ll have some extra cash available to retire debt and help with living expenses.  For younger Canadians saving money at the gas pump? Investing the extra cash flow in your TFSA account will certainly help towards building a healthy deposit for your first home.

  • Don’t squander the cash you are saving thanks to low energy prices.
  • Your TSFA if you have one, allows you to invest those savings and the returns you earn are tax free.
  • If you don’t have a TFSA, then get one.
  • Be sure to use only qualified investments and do not over-contribute. The penalties are severe.
  • Money earned on your investments is tax-free.
  • Take out cash when you need it, and put it back when you can.
  • When you retire, money withdrawn from your TFSA does not count as taxable income.


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.














Building a Strong Foundation

Now that we have a good handle on the big picture we need to put together a plan to get us to where we want to go. Yes, we are going to talk about budgeting. I know a lot of people have a strong emotional diversion to the word budget. They equate it to a four letter word. If I go on a budget I won’t be able to do anything fun anymore. I won’t be able to go out for drinks, go shopping, or do anything except save for retirement.

A budget is not a tool for taking anything away. A proper functioning budget is a tool to help you get the things you really want in life now and in the future. The biggest thing a budget does is help you decide what you really want. Do you want to get out of debt faster, do you want to have money to go on vacations, do you want to save for retirement, do you want to renovate your home, do you want to save for a child’s education?

In order for a budget to work you have to look at your expenses ANNUALLY and then break them down into a monthly allotment. The regular every month expenses are not the things that usually mess with a budget. The things that mess up the household finances is the “surprise” expenditures. Things like school fees, vehicle expenses, holidays, and household repairs.

A simple way to put together a working, functioning is to use the three account method. The first account is simple. It is for your monthly fixed expenses. These are the expenditures that happen every month and the amount does not change. Things like mortgage or rent, loan payments, monthly investments, insurance payments, monthly property taxes and condo fee, even some utility payments. This is a flow through account. Money goes in, money goes out. Do not keep insta-broke access on this account.

The second account is for your every month expenses where the dollar amount fluctuates. Things like groceries, gas for your vehicles, toiletries and household items, eating out, pet expenses, entertainment, and the all encompassing miscellaneous category.

The third account is the “save your budget” fund. This is for all the expenses that creep up throughout the year, but are not monthly. Things like birthday, Christmas, and other holiday gifts, vehicle expenses such as oil changes, tires, repairs, and registration, clothing, school fees, home repairs, and vacations. Whatever comes up for you throughout the year.

I also suggest setting up separate savings accounts for the things we want to save for like a vacation, home renovation, or anything big we want to do. Seeing our money grow is a very positive and motivating thing. Personally I’m a big fan of ING Direct ISA accounts. No fees, they actually pay a little bit of interest, you can have and label up to five different accounts, and it separates the money just a teeny bit.

Creating a budget does not need to be complicated. But it does need to work. Keeping it simple, taking into consideration all the places your money needs to go, and making conscious decisions is where you need to start. This is the foundational piece to financial prosperity.

“The cold harsh reality is that we have to balance the budget.”
Michael Bloomberg

Invest like you shop and your savings won’t drop!

Huge lineups of shoppers looking for deals on Black Friday and the massive retail sales that occur the weeks after Christmas are testimony to the ability of people to shop wisely.  I know many families that defer buying expensive gifts (for their kids but especially for themselves) until after the Christmas holiday in order to save hundreds of dollars.  So why are people so bad at investing their money?

A recent study by Blackrock, the largest money management firm in the world, confirmed what all of us know already:  The average investor sucks at investing.  Despite the fact that the skills and emotional fortitude necessary for successful shopping are pretty much applicable to the task of investing one’s money, it seems the average person just won’t use these abilities when making important investment decisions.

According the the American Research Group Inc., the average shopper plans to spend $854 on gifts this year. Let’s assume it will be the same next year and the next.  Virtually everyone realizes that since they’ll be spending the money anyway, shopping smartly and getting all gifts at perhaps a 20% lower price leaves them better off.  Wealthier in our example by more than $500 after three shopping seasons in fact!

But when it comes to buying investments, investors prefer to pay a premium.  What proof do I have?  Many years of observation, but the results speak for themselves.

The average investor managed to earn less than virtually all asset classes at his disposal earned over ten years according to the Blackrock study.  To be perfectly honest, I’m surprised the average investor did so well.

I’m not sure about how the study was conducted.  If everyone that participated had a home and kept all their money in a checking account….the result wouldn’t be very surprising would it?  Let’s assume that the sample was comprised of real “investors.”  Some with homes and minimal savings, but others actively investing serious money in both bonds and stocks. Where would they be going wrong?

It’s hard to imagine retail investors trading aggressively in the bond market, but assuredly a significant amount of their long term savings could include fixed income securities.  It’s equally difficult to conceive that the lion’s share of their savings might be in gold or oil.  Likely, the average investor does include stocks in his retirement savings and participates actively in decisions.  He/she would either use an adviser to implement asset allocation decisions or occasionally channel money into or out of funds.

Consider one proxy for stocks, the S&P 500 Index over roughly the same time frame as the study.  It’s certainly been a rollercoaster, but a simple buy and hold strategy would have contributed nicely to the average investor’s nestegg.  In my opinion the only way the average investor could have done so poorly is by losing money making poor investment calls along the way.

Generally, folks wait until the stock market has climbed quite a long way upward before committing their own money – see the “Buy” indicators on the graph?  This decision is made based on the past performance charts and tables that are promoted ad nauseum by the investment industry when the rates of return earned by their funds have been excellent.

Even though past performance means nothing, for some reason impressive historical returns awaken the greed in all of us, just like an extremely large lottery jackpot suddenly inspires many more people to go out and buy lottery tickets.

Unfortunately, great historical performance is very often followed by lousy market environments – evidenced clearly by the graph of the S&P 500 Index over the ten year period.  As anxious as people are are to pile into a market that has been rewarding (after-the-fact), they are just as eager to get out of a losing situation that leaves them feeling they’ve been suckered.  The average investor sells at the worst possible time.  A few of these buy high/sell low episondes is sufficient to reduce the overall return he/she has earned in other assets like bonds or the family home.

Put another way, the shopper in you is always on the lookout for discounts while the investor is more than happy to pay a premium to the list price.  Greediness completely overides any bargain-hunting intuition.

Back to our shopping example.  Imagine that you can shop wisely and get gifts at prices 20% below list.  But also imagine that you and your family can use those gifts for a time and then sell them at a 20% premium to list.  Crazy?  You can actually do this with your investment portfolio.  Apply those shopping skills to your savings and you’ll be surprised how much better off you can be.




Malvin Spooner.