Double Blind

Everybody’s financial situation is slightly different, but it’s funny to be reading the advice given in newspaper columns with respect to RRSP contributions. Some general rules:

1. If you have high interest-bearing debt (e.g. assuming you think you can get a 6% return on the market, if you are paying more than 6% on the debt), pay off the debt first and don’t bother with the contribution.

2. If your 2008 net income is $37,885 or under, don’t bother with the contribution. If you’ve already paid down your debt and really want to contribute to something, then consider putting the money into a TFSA. If your net income is slightly above $37,885, then contribute enough to your RRSP such that you bring your net income down to $37,885, and put the rest into the TFSA.

If you pass these two conditions then determining what to invest in is the challenge. Generally, put tax-disadvantaged investments inside the RRSP and TFSA. RRSPs are good for US income bearing investments (as they are not subject to withholding tax inside the RRSP). TFSAs are good for all other domestic income bearing investments (as foreign investments will still have withholding tax applied to them, reducing future gains).

One reason why I like bonds is the following:

Limited Brands reported a bad (not terrible) quarter, and thus their stock got hit today. However, the overall picture of the business is not bad. They still made plenty of money for the year (about $219 million, after you back out the non-cash goodwill impairment charge), and have substantial liquidity.

The bonds contained within HJR (which is a trust) mature in 2033 (24 years from now), and give off a 6.95% coupon, and they also trade at around 54 cents on the dollar. HJR gives off a 7% coupon, and trades at 40 cents on the dollar (giving it a current yield of about 17.5%).

Eventually when the credit crisis stops, the bonds will trade upward to reflect a higher chance of a return of principal, and when this happens, the trust containing the bonds will also rise – my estimation is that they will go for around 9-10%, which will mean a fair value of roughly 70-78 cents on the dollar, or about a double from present levels. In order for equity to break even with this, you would need to see an LTD share price of about $15/share.

Of course, if LTD does wildly successful in the future, then the equity will go much higher, and investing in equity would have been the proper decision. However, the risk that is taken in order to get such a return is substantially higher, and the retrospective analysis of saying “I should have done that” is about as useful as saying “I should have picked these numbers for the lottery and I would have made a million dollars.”

I suspect the only reason why HJR is trading at such a discount is because it is illiquid, and it is unmarginable (at least at Interactive Brokers). Otherwise you could buy HJR and short the underlying bond and arbitrage the difference.

Earlier I was worried that the Canadian Pension Plan (which doesn’t include contributions from Quebec, and thus doesn’t pay people that worked inside Quebec) was going to post huge investment losses in the last quarter of 2008. Fortunately, they did not (6.7% loss).

However, the Quebec Pension Plan (of which is partially managed by the Caisse de dépôt et placement du Québec) posted a whopping 25% loss on investments which can be described as nothing other than disastrous. The absolute amount was about $40 billion.

They lost about $8.9 billion trying to hedge currencies – the Canadian dollar dropped and thus had they not hedged, they would have been able to realize much higher gains. They also took a $4 billion mark-to-market hit on asset-backed commercial paper (ABCP), which has lost all liquidity in the marketplace, and thus they will have to pay a liquidity premium to convert to a more conventional income-bearing investment. They subsequently converted the foreign ABCP in January.

The most funny line in their press release is rationalizing this hit:

Without the ABCP factor, the Caisse’s five-return year would be 4.1%, which is above the median of its peers, namely 3.6%, and close to the first-quartile threshold of 4.3%. Over the past 15 years, the Caisse has had a second-quartile five-year return only twice, in 1992 and 1999. As a result of ABCP, the five-year return is instead 3.1%, or 0.5% below the median of its peers.

This is kind of like saying “If I didn’t invest in Enron, Worldcom, Nortel, Bear Stearns, and Lehman Brothers, we would have performed better than our peers.”

Sounds like the pension fund managers need to be fired. I should really get into the business.

I find it so interesting that the numbers for organized crime are as transparent as in this report:

Jan. 30 (Bloomberg) — Revenue raked in by Italy’s mob surged 40 percent last year, turning crime into the nation’s No. 1 business, Eurispes said in its annual report.

Income increased to 130 billion euros ($167 billion), up from about 90 billion euros in 2007, according to figures supplied by Eurispes and SOS Impresa, an association of businessmen to protest against extortion. Drug trafficking remains the primary source of revenue, bringing in about 59 billion euros, and the mob earned 5.8 billion euros from selling arms, the Rome-based Eurispes research group said today.

I wonder how they get their estimates. Does the mob have the file with an internal securities and exchange commission?

I’d also be curious to know the size of revenues for organized crime in Canada; my guess is that the numbers would be absolutely shocking (my estimate would be around 10% of GDP or about $130 billion a year), but the reason why nobody cares is that these numbers are not revealed to the public for obvious reasons. You can’t complain about what you can’t measure, right?

… then international bank securities are probably your ticket.

For example, ING Group’s perpetual debt securities (referred to as hybrid securities) are trading at very low valuations; there is a high amount of risk associated with such securities. However, if the financial markets do stabilize (along with the banks), they will turn out to be the investment of a generation. That’s a big “if”.

Examples include ISG (6.125%), ISP (6.20%), IND (7.05%), INZ (7.2%), which are all functionally equivalent securities except for the coupon. Their seniority is one step above common shares, and one step below bonds. Perhaps more importantly, they are one step above the Tier-1 securities agreement that the bank made with the Dutch government (which was a 10 billion Euro loan made by the Dutch government, plus an assumption of 80% of ING’s USA sub-prime asset portfolio with a risk-sharing arrangement).

All of the securities have a liquidation provision where you can be called out at $25/share by ING Group, but considering that these securities are trading well below that, it will not be a factor. Functionally, this will only happen if the bank will be able to obtain credit at a rate better than the coupon payment, which isn’t going to happen anytime soon.

If you were to speculate on these issues, you have to assume by proxy that ING Group will be recovering. The common stock is likely a bad investment, but the perpetual debt securities will probably benefit the most from some sort of financial recovery. I would choose the low-coupon issues (ISG or ISP) because you want to pack in as much of a capital gain as possible assuming there is a recovery. Since ISG and ISP trade roughly at 18-19 cents, the market is pricing in a very high probability of ING Group exercising their option to defer interest payments (see the prospectus). However, if they do not, you are sitting on something that will yield an income of about 33-34%/year, plus capital appreciation (about 3x assuming a return to a “normal” 12% yield).

Again, high risk, high reward. The risk is more than likely to occur than the reward, however, which is why I would call this trade “gambling” if you choose to do it.

James Hymas runs the PrefBlog (an excellent blog on preferred shares trading in Canada), but he wrote an article on Canadian MoneySaver on bond characteristics, which can be found here. In particular, the discussion on term risk is very fruitful.

Reinvestment risk is also mentioned. This is when you receive coupon payments or are called out on your investment, and have to put the proceeds in another form of income-bearing security. The yield to maturity quoted on most bonds assuming that coupon proceeds are invested at the same yield as the yield to maturity.

I find it funny how the politicals out there extol the virtues of “building up savings”, while drafting up policies to encourage as much spending as possible.

Right now, the interest rate environment is designed to punish those people holding onto cash – ING Direct gives out 2.3% on short term money currently, and a 1-year GIC yields 2%.

Here is something I have never seen before – American Express is offering $300 to those people that agree to close their accounts by the end of April and pay off their balances (from Reuters):

NEW YORK, Feb 23 (Reuters) – American Express Co (AXP.N), battered by mounting credit card losses, is offering $300 to a limited number of U.S. card holders who pay off their balances and close their accounts, the company said on Monday.

“We sent the offer out to a select number of card members,” said Molly Faust, a company spokerwoman. “We are looking at different ways that we can manage credit risk based on the costumers overall credit profile.”

The company did not say how many card holders would receive the offer and did not disclose the total of their card balances.

Card holders have until the end of February to accept the offer and must close their accounts in March or April. Each card holder will receive a $300 pre-paid American Express card.

On a side note, I’d love to know what a “spokerwoman” is – I literally copied and pasted this article.

You can be sure that the people American Express are targeting are those that are not credit-worthy individuals. So how come they get rewarded for being such bad customers?

Strange world that we live in – perhaps this is why so many have decided to just say “screw it all” and spend like there is no tomorrow – simply because it makes no difference in the end since they will be bailed out.

A spin on an Albert Einstein quote is that “Things should be as simple as possible and not simpler.”

Probably the most complex system on the planet is determining how government legislation interacts with other government legislation. While there are monstrosities involving topics such as the income tax act, frequently spending programs run into the same problem. An example of some unintended consequences of an overly complex system involves people taking actions such as the following:

OLYMPIA, Wash. The state of Washington sent out $1 checks to the 250,000 food stamp recipients in the state.

The director of the Community Services Division for the Department of Social and Health Services, Leo Ribas, says the checks mailed Feb. 17 trigger an additional $43 million in federal food benefits. They also connect recipients to an energy assistance program.

Ribas says the $1 check is a one-time move to leverage the federal money. He says next year the state will be able to trigger the federal assistance through a routine deposit in food stamp accounts.

It was in the individual interest of the state of Washington to mail out the cheques – assuming it costs $1 to process and mail out the cheques, they will receive about $43 million for a $500,000 expenditure.

However, the system as a whole (the combined Washington State – US Federal government) loses because of the lack of efficiency on the transfer.

Examples like these, which are examples that nobody could have thought of when drafting legislation to enable spending on such programs, is why things should be kept simple – the more complex you make things, the more opportunity there is for odd behaviour such as this to become in the rational self-interest of those involved.

There are plenty of examples in our taxation system that result in the same ‘odd’ behaviour.

HJR and PZB are functionally identical securities, with the notable exception that HJR has a 7% coupon, while PZB has a 6.7% coupon. Both give out coupons at identical times (at the end of February and August each year) and are backed by the same security (debt of Limited Brands, due March 1, 2033).

You would think HJR and PZB would trade in a similar fashion, and HJR would also trade slightly higher than PZB (to account for the extra 0.3% coupon), but nope!

Right this second:

HJR, bid 9.70, ask 10.38 (let’s pretend you get it at 10, this is a current yield of 17.5%).
PZB, bid 12.00, ask 13.00 (let’s pretend you get it at 12.50, this is a current yield of 13.4%).

Par value on these two securities is $25/unit.

The underlying debt (coupon 6.95%) has traded around 49 to 54 cents on the dollar in the month of February.

In theory you could arbitrage these two by purchasing HJR and shorting PZB, but the reason why this doesn’t work is because PZB is unshortable. You could also try buying HJR and shorting the underlying debt, but the debt is not shortable.

The market has been exhibiting all sorts of these “unarbitragable arbitrages”, and it is a good indication how dysfunctional credit markets have been behaving lately.

An investor can take advantage of the situation by shopping properly for securities – if they believed that Limited Brands will remain solvent for the next while, or the perception of solvency will increase, then they can look at all the available securities and choose the cheapest one. Normally the market likes to price these things rationally (i.e. equivalent yields for equivalent risk), but not anymore it seems.

The Saturday, February 21, 2009 Lotto 6/49 draw was for a $48 million jackpot, which gave it the unusual characteristic of having a higher expected value than the price of a ticket, assuming that two or less people win the main prize.

My hopes of striking it big were dashed when I did not win. (Update: 3 from Ontario, and 1 from Quebec won the main prize… isn’t that always the case?)

This is twice in a month that I’ve played the Lotto (see the previous post), so one more time and another $40M+ jackpot probably means I’ll have to check myself into lottoholics anonymous or something. Being a statistical junkie does have its disadvantages.