Double Blind

Looks like that somebody else has the general strategy I have been pursuing financially over the past half year:

“In the last six months it’s practically all the investing Third Avenue Value Fund has done,” he said. “I got so spooked by the stock market and the terrible performance in 2008. If I buy a performing loan with 30 percent yield to maturity, I don’t have to worry about the stock market.”

Back in February and March (and most specifically the bottom was in the first week of March), most of these investments were ridiculously undervalued. Now finding those 30% yield to maturities is much more difficult – the types of debt you have to invest in are of companies that are much more shadier. If you lower your debt expectations down to 20%, there are a lot more candidates around.

It is really difficult having to make subsequent investments at lower rates of returns, especially knowing the price you could have received earlier, but you can never base investment decisions on what historical asset valuations are – you can only look at the price that you are being offered today, compared to what your extrapolation of value is for the future.

Currently I own some long-term corporate debt issues in the form of trust preferred securities. They generally have a maturity of around 20 years, and are currently yielding around 13-14% depending on what day you get a quotation. Obviously they are speculative-grade debt, but the underlying companies are well known names and generally have balance sheets that aren’t completely clean, but they are certainly not on the verge of bankruptcy by any means in terms of both liquidity and solvency.

Since inflation will be increasing, am I being sufficiently compensated for the risk that I am taking? The following is a snapshot of composite bond rates:

Maturity	Yield	Yesterday	Last Week	Last Month	Yield Change	Spread
2yr AA	2.22	2.20	2.12	2.86	0.35	1.26
2yr A	3.52	3.48	3.39	4.60	0.36	2.56
5yr BBB	-	-	5.82	5.82	-	3.41
5yr AAA	3.01	2.92	2.99	2.85	0.11	0.60
5yr AA	3.89	3.66	3.71	3.51	0.31	1.48
5yr A	4.42	4.34	4.37	4.83	0.11	2.01
10yr BBB	-	-	6.24	6.24	-	2.53
10yr AAA	4.86	4.74	4.51	4.50	0.15	1.15
10yr AA	5.02	5.15	4.70	4.51	0.08	1.31
10yr A	5.97	6.13	5.50	5.35	0.12	2.26
20yr BBB	-	-	6.69	6.69	-	-
20yr AAA	6.56	6.48	6.33	6.55	0.00	-
20yr AA	6.05	5.97	5.82	6.04	0.00	-
20yr A	6.88	6.66	6.51	6.72	0.15	-

 
We see that 20 year A-rated debt has a composite rate of about 6.9%; presumably less than investment grade debt will be yielding higher. The question is whether that 13-14% is worthy compensation? Will yields rise as long-term interest rates rise?

This is a very good question, and ones that I do not have answers to. I do know, however, that I would feel more comfortable with shorter duration debt investments.

Today was a record-making day in the US bond market, but something that probably won’t make too many financial headlines – apparently the spread between the 2 year treasury bond and the 10-year treasury bond is at an all-time high.

US Treasury Bonds

Maturity	Yield	Yesterday	Last Week	Last Month
3 Month	0.14	0.15	0.15	0.06
6 Month	0.28	0.27	0.25	0.27
2 Year	0.96	0.91	0.83	0.87
3 Year	1.48	1.45	1.29	1.29
5 Year	2.40	2.30	2.02	1.84
10 Year	3.72	3.55	3.19	2.91
30 Year	4.62	4.49	4.14	3.83

What is happening in the markets are clear – the US is trying to inject cash and inflation back into the economy with quantitative easing – basically printing up money in exchange for US treasury debt. This has the effect of slamming the currency, as we can see with the chart below:

Now, when the US currency has depreciated enough due to quantitative easing, because the US’s fiscal deficit is so high, they are forced to raise money by going to the bond market. This has the effect of depressing bond prices and increasing yields:

One of the worst predictions I made was saying that the 30-year treasury bond yield would be under 3% by the end of 2009, but fortunately I never took any financial action on this – and I have long since realized that I am completely wrong, mainly because I dramatically underestimated the velocity of the marketplace.

Although in the immediate short term, now that everybody’s eyeballs are looking at the bond market, we might start to see some subsiding of long-term rate increases, the trend is very clear – rates are rising. There is no way that the US can continue to shell out $2 trillion dollar deficits and not have one of the currency or bond markets choke on the massive issuance of paper.

How does one defend against this? Get money out of US-denominated assets, and move your capital to Canadian sources, and invest it in any hard assets other than real estate (e.g. fossil fuels). Although we’ve got our own fiscal basket case to deal with, it is nowhere close to what the USA is going through.

My other guess is that as long-term rates continue to rise, the subsequent rise in rates in the mortgage market will continue to depress housing.

The government is bringing in some proposed amendments to the Canada Pension Plan. This will require a change in legislation, so it is most unlikely to pass because of the minority government situation. The changes are easy to analyze, and one of the changes (Change #4) will have a significant effect on when most Canadians will choose to take CPP (it will induce more people to take CPP later in life).

Change #1:

To remove the Work Cessation Test in 2012. Individuals would be able to take their benefit as early as age 60 without any work interruption or reduction in hours worked or earnings.

This is a logical amendment considering that most people were effectively not ceasing work before taking CPP. The definition of work cessation was also quite nebulous – you could take a leave of absence for two months and have that considered to be ceasing to work. It was a rule that has long since been depreciated in the modern workforce.

One advantage of taking CPP early is that if you planned on continuing to work, you would not have to pay CPP, in addition to receiving an extra source of income. This would no longer be the case after Change #3.

Change #2:

To increase the general drop-out:

* To 16 percent in 2012. This would allow a maximum of almost 7.5 years to be dropped.
* To 17 percent in 2014. This would allow a maximum of 8 years to be dropped.

This will positively affect people that have multiple years of low income years. In addition, since the average income for CPP purposes is calculated from the age of 18 and onwards, if people do end up working for 42 years before they take CPP at age 60, this will exclude 7 low-income years vs. 6 before this change. Since most people earn less money at the beginning of their careers, it will improve their average income for CPP purposes.

In addition, if you have a child, you can creatively use them to exclude 6 years of “CPP time” after they are born to optimize your or your spouse’s CPP benefit. In theory, if you have one child and take your CPP when you are 60 years old, you can exclude up to 13 years of a 42 year working period. If you had worked for those 13 years and had no children, you would have still received the same CPP benefit despite having contributed to the fund for that time!

Change #3:

To require individuals under the age of 65 who receive a CPP retirement benefit and work, as well as their employers, to make CPP contributions that will increase their CPP retirement benefit. This would be voluntary for individuals aged 65 or over, but employers of those opting to participate in the CPP would be required to also contribute.

* These contributions will result in increased retirement benefits, including persons already receiving the maximum pension amounts.
* The additional benefits would be earned at a rate of 1/40th of the maximum pension amount ($10,905 in 2009) per year of additional contributions. The exact amount of the additional benefit would depend on the earnings level of the contributor. The resulting pension could be above the maximum.

This change forces people that take early CPP to continue paying CPP contributions if they continue to work. However, unlike present, that amount enables people to increase the amount of CPP benefits they receive.

Using 2009 figures, if you took CPP at age 60 and continued to work and paid the full CPP premium amount ($2119 yearly for the employee) for five years, you would increase your monthly CPP benefit at age 65 by 12.5%, or about $1363 per year. The raw math is that you would contribute a net $10,595 over five years to the CPP (plus another $10,595 from the employer), and have an additional yearly return of $1363 per year when you turn 65. This works out to a pension with a 6.4% return on investment, ignoring time-value of money and other external factors. In low interest rate environments, you would ‘win’ with this, but in high-rate environments you would lose.

Coupled with Change #4, however, this change is a net loser for those that decide to take CPP early.

Change #4:

* To gradually restore the pension adjustments to their actuarially fair levels.
o The early pension reduction would be gradually increased to 0.6% per month for each month that the pension is taken before age 65. This would be done over a period of five years, starting in 2012.
o The late pension augmentation would be gradually increased to 0.7% per month for each month that the pension is taken after an individual’s 65th birthday, up to age 70. This would be done over a period of three years, starting in 2011.
* To require regular reporting on the actuarially fair level of the pension adjustments at least every nine years, starting in 2016. Finance Ministers will review these adjustments, based on an assessment by the Chief Actuary of the Plan, and recommend whether changes are needed.

Currently if you take CPP at age 60, you will receive 30% less than what you would be entitled to at age 65. Each year you wait, you would earn 6% more, relative to the age 65 level. If you waited until after age 65 to take CPP, you would earn 6% more per year over the age 65 pension level, up to a maximum of 30% extra for CPP when you turn age 70. The two decision-making variables are what your projected lifespan is, coupled with your cash flow requirements (and whether you think cash spent earlier at that time of life is more effectively spent than later in life). Taking CPP later than 65 years of life is currently a bad decision, and most people (especially men that have lower life expectancies, such as smokers or those with medically adverse family histories) have very good reasons for taking CPP as early as possible.

Mathematically, your “return on investment” for not taking CPP at 60 is incorrectly calculated by assuming the reward for waiting is 6% a year. Although the difference between taking CPP at the age of 60 vs. 61 is 6% different, it is the difference between -30% and -24%, which is actually 8.6%. From age 61 to 62, the return is 7.9%; 62 to 63 is 7.3%; 63 to 64 is 6.8%, and 64 to 65 is 6.4%.

If you think you can invest money better than a risk-free 8.6%, then taking CPP early at age 60 is a good decision.

What this change does is punishes people taking CPP early by increasing the risk-free amount they would have to earn for a break-even decision. This is a subtle change that reduces CPP benefits for those that want to retire early, and will induce more people to taking their CPP retirement later. In other words, it is a net actuarial gain for the CPP fund (and a reduction of benefits for future pensioners).

With a 0.6%/month decline in benefits for pensions taken earlier than age 65, the following are the risk-free amounts that must be earned in order to make early CPP a breakeven financial decision, compared to that of the old CPP system:

	Old System	Old System	Proposed	Proposed
	CPP Benefit	Risk-Free Return	CPP Benefit	Risk-Free Return
Age	Relative to Age 65	Required	Relative to Age 65	Required
60	70%		64%
61	76%	8.6%	71%	11.3%
62	82%	7.9%	78%	10.1%
63	88%	7.3%	86%	9.2%
64	94%	6.8%	93%	8.4%
65	100%	6.4%	100%	7.8%
66	106%	6.0%	108%	8.4%
67	112%	5.7%	117%	7.7%
68	118%	5.4%	125%	7.2%
69	124%	5.1%	134%	6.7%
70	130%	4.8%	142%	6.3%

 
Interestingly, there is a slight marginal benefit to wait until age 66 to claim your CPP as the proposed change increases the CPP benefit by 0.7% per month after 65, instead of 0.6%. If your risk-free threshold is 8%, then you will likely wait until you are about 66 years old before applying for CPP benefits.

Almost nobody will be able to get an 11.3% risk-free return at age 60, so it is very likely that most people will wait before collecting CPP. In the old system, the threshold is 8.6%.

In most cases, the net return of a working Canadian’s investment in CPP is significantly worse than if you managed your own retirement. If you can manage your own money in a tax-sheltered (RRSP or TFSA) account with a return of 4%, you will do significantly better than the CPP. There is also the distinct advantage of having full and free access to your capital during this period of time.

The Canada Pension Plan makes no distinction between contributions performed early in life vs. later in life – a Canadian contributing a full yearly CPP amount at age 59 is treated no differently than a Canadian with a full yearly CPP contribution at age 18. As a result, if one wishes to fully take advantage of the system with its present rules, it is only worth contributing to the CPP later in life than earlier. For example, somebody working between the ages of 18 to 38 will receive exactly the same amount from CPP as somebody that works from ages 38 to 58 (assuming the same salary, and both people taking CPP at the same time). It is correct to say that the Canada Pension Plan amounts to a wealth transfer mechanism from younger workers to older ones.

The Governor General is a figurehead position in our constitutional democracy (with some reserve powers for very unusual circumstances), so her actions typically are for ceremonial purposes rather than the actual governance of this country.

Recently, she went to Nunavut and ate some raw seal heart after slicing some meat from it.

RANKIN INLET, Nunavut – On the first day of her trip to the Arctic Michaelle Jean gutted a freshly slaughtered seal, pulled out its raw heart, and ate it.

Hundreds of Inuit at a community festival gathered around as the Governor General made a gesture of solidarity with the country’s beleagured seal hunters.

Jean knelt above a pair of carcasses and used a traditional blade to slice the meat off the skin.

After repeated, vigorous cuts through the flesh the Queen’s representative turned to the woman beside her and asked enthusiastically: “Could I try the heart?”

Afterward Jean grabbed a tissue to wipe clean her blood-soaked fingers, and explained her gesture of solidarity with the region’s Inuit hunters.

It’s one thing to talk about protecting the seal hunt. It’s another matter to take action and do what the Governor General did. Although I’m sure it was well scripted by her handlers, the fact that she was willing to show her support by involving herself with the activity speaks volumes. My opinion of her went up.

This article from the CBC sums up what’s wrong with our judicial sentencing:

A man belonging to the so-called Toronto 18 terror group was sentenced to 2½ years in prison Friday, becoming the first person convicted in a domestic terrorism trial in Canada.

The judge in Brampton, Ont., who sentenced the 21-year-old man declared that, with credit for his time already spent in custody, the man had served his time and could be freed.

The man was found guilty in September 2008 of participation in a terrorist group that was plotting to blow up buildings in downtown Toronto.

He was not a ringleader and his involvement included attending two terrorist training camps, shoplifting items from a Canadian Tire store and removing a surveillance camera.

In passing sentence, Justice John Sproat described the man’s crime as “very serious,” but also noted he had expressed genuine remorse.

In a letter to the court, the man promised to work hard to contribute to society and declared, “I do not believe in participating in violent acts against anyone.”

I find the concept of people convicted of crimes expressing “genuine remorse” to be silly – mainly because such remorse would never be exhibited if it wasn’t in the beneficial interest of the convicted (in this case, the beneficial interest would be a reduced sentence). There is no penalty for ‘lying’ when remorse is expressed. Instead, there is a huge reward for acting in front of the judge.

Actions speak louder than words, and the action here was fairly clear – the guy was actively involved with a group that had the goal of blowing up buildings in Toronto.

A lot of people get confused when they criticize our judicial system, so I will be a little more explicit. There is the criminal court procedure, and there is sentencing. My take is that our criminal procedures are fine (albeit slow) – they should be structured to putting as much burden as possible on the prosecution, using reasonable rules concerning the acquisition of evidence, to prove beyond a doubt that the alleged crimes have taken place. The intention of such a system is that people that are truly or marginally innocent of crimes should never be convicted, and the false conviction ratio of court cases should be as low as possible, even if it means that some guilty individuals get out for their crimes because of marginal evidence in court cases.

My problem with the judicial system lies purely with sentencing of the guilty, which appears to be structured to only deter murder in terms of strict sentencing. Other crimes, such as theft and fraud generally do not receive sentences that sufficiently deter such activities. The terrorist example above just solidifies the fact that if you are going to be getting into a criminal enterprise, that Canada is the best country on the planet to be in since your potential downside is significantly less than what it would be in other countries.

There will always be a small fraction of the population that will be perpetual criminals, and these criminals account for a disproportionate amount of criminal activity. The best predictor of future crime is previous criminal activity. The goal of the sentencing system should be to keep these people in jail, and with sentences like we have seen, there is no effective deterrence.

The Canada Pension Plan reported another losing quarter today; they made quarterly data rather difficult to extract because they were using year-end data. The CPP managed to lose $6.3 billion in assets between the end of December 2008 and March 2009 (they took in $2.9 billion in CPP contributions and lost $3.4 billion in the total portfolio, which implies that their investments went down $6.3 billion). On an average asset base of $107.2 billion for the quarter, this represents an approximate 6% loss for the quarter.

For the year ended March 31, 2009, the CPP lost 18.6% on their investment portfolio. This is quite a bit better than the 39.3% loss the S&P 500 had over the same time period, and 34.1% for the TSX Composite.

The big warning sign, however, is the following:

The four-year annualized return of 1.42 per cent is less than the 4.2 per cent average real rate of return that the Chief Actuary of Canada estimates is required to help sustain the Canada Pension Plan over a 75-year period. Over this long timeframe we expect that there will be four-year periods where returns are above or below this threshold. In the ten years since the CPP Investment Board began investing, returns for the CPP Fund in all four-year periods prior to fiscal 2009 exceeded the 4.2 per cent real rate of return. Based upon historical experience and reasonable future return expectations, the CPPIB believes that the actual returns for the CPP Reference Portfolio and the CPP Fund will exceed the 4.2 per cent real return assumed by the Chief Actuary over the long investment horizon for the CPP Fund.

A 4.2% real rate of return is typically around 7-8% before inflation. Readers here will know that my inflation expectations will increase over the next few years, which will make realizing a 4.2% real rate of return not a trivial level to achieve when you are dealing with a $100 billion investment base. Investing with this much in assets is a significantly different game than at the retail level because liquidity is a huge deal – when you invest $1000 in something, you can do so with a mouse click. When you invest a billion dollars into something, it can take months to get in and months to get out. The worst part is that your involvement in the market will have an effect on the price you receive.

Inflation will be rising in the USA. Now some top names are speaking publicly for it as the only way to de-leverage the US’s debt. From an economic perspective, this makes a lot of sense – either you pay back debt by cutting spending, and raising revenues (through taxes), or you can reduce the bill to be paid through inflation.

Politically, inflation is a much less transparent mechanism of repayment, so this is what will happen since most governments are too spineless to tell the public that they’re going to be cutting government services, or raising taxes.

Who wins in an inflationary environment? Anybody that has issued debt and paying it back years later.

Who loses in an inflationary environment? Anybody that bought the debt. The economy, in general, also pays for inflation, as you will have decreased growth resulting from higher effective rates of interest.

Essentially a change in inflation is the rate that wealth transfers from savers to borrowers.

There is a very fine financial balancing act that will be going on in the next few years – if you raise inflation too high, you will crater the currency, which carries much larger ramifications. Also, high inflation has the effect of increasing the real rate of interest (i.e. a 2% interest rate plus 6% inflation means the effective rate of interest is 8%), and this will having a dampening effect on the economy.

The USA is living in a fiscal dream world – they will be spending $1.8 trillion dollars this fiscal year more than they take in, and this is money that has to be soaked up somewhere – eventually investors in the US economy will be demanding much higher rates than the 4.21% (30-year duration) they are asking for presently, especially if the currency inflates at a higher rate.

What does this mean for Canada? It means that our currency is going to rise against the US dollar. If we really get our fiscal act together and start cutting off the deficit again, it also means that our purchasing power will dramatically increase over the next few years. This will generally be bad for exporters, but will be good for our domestic economy. Coupled with an increase in the price of oil and commodities, it means that our economy might recover faster than anticipated.

I did not anticipate this happening so quickly, but it is. This was my basis for my 2008 year-end prediction that the Canadian dollar would be at or lower than the US currency at year-end 2009. While this might still materialize, it won’t be since this economic impact is being priced in a lot faster.

Sharp business managers that deal with a lot of US-denominated exports would have been very smart to hedge their currency risk while the Canadian dollar was still at around 80 cents back in March. Fortunately I did some transactions at that level, but not enough. Even today, at 86-87 cents on the dollar, a currency hedge would still be a wise decision.

Inflation makes the value of long-term bonds vulnerable. Having some long-term corporate debt in my portfolio, one has to make sure that they are properly compensated for the risk they are taking, including inflation. Right now I’m being compensated with a current yield of 13% for this, which is about 9% above treasury bond rates, but is this enough when you factor in inflation?

The other way to hedge yourself is through the purchase of equities – specifically companies that have hard assets that are difficult to replace, and with those assets generating inflation-adjusted cash flows. Telecommunications firms (e.g. Shaw/Rogers/Telus/Bell), railroads (CN/CP) are two categories that are linked to this. Commodity producers (e.g. Suncor, Husky, etc.) are also in this category, but you have to assume other external variables, such as the demand/supply dynamics of the underlying commodity. It is not good to blindly purchase some companies without doing proper valuations, but it is virtually guaranteed that all eight firms I mentioned here will be around in five years, and end up preserving your assets in an inflationary environment.

If we see 6% inflation over the next five years, this would imply that the assets would increase about 33% in value from inflation alone; add in another 8-9% return would imply a nominal return of about 15% a year.

All of these calculations exclude the impact of taxes. The cost basis is not indexed to inflation, which is a further erosion on capital (if the investment is sold).

The implied volatility on the S&P 100 index options has gone below 30% for the first time since September 2008. This measure (frequently called the VIX) is typically used as a ‘gauge of fear’, although this is an incorrect description. Right now it is at about 28.5%.

This is a fairly good indication that the market panic is over. I still wouldn’t start buying equities blindly, but it would be safe to assume that the majority of the turbulence seen in the past 9 months is behind us.

I no longer use desktop systems. I find that notebooks with large screens are more than sufficient for my needs, plus the added benefit of being able to carry them when I need to. I do always, however, try to look new systems once in awhile. Since I spend so much time in front of a computer, if I can do things faster with newer hardware or software, the money spent will be well worth it.

My main workhorse computer is a Dell Vostro 1710 notebook. It has a 17″ display, a 1.8GHz Intel Core 2 duo, 3GB RAM, a 1.3MP webcam and microphone embedded on the display, and Windows XP (bought just before they started charging you more for it, which was the middle of June 2008). The hard drive was 250 gigabytes, integrated Intel display, and a 802.11 a/b/g/n wireless card. The notebook has served me well, and I hope it will continue doing so for another few years. At a minimum, I have another 13 months of warranty on it before it will blow up.

This system cost me $825 before taxes. I recall having to go on a little fishing expedition for a $100-off online coupon, and also recall that I had a choice of paying an extra $150 for the 2.0 GHz Core 2 Duo instead of the 1.8 GHz processor, but I thought the trade was not worth it.

What I am finding very strange is that a year later, the closest thing I can get for $825 on Dell is roughly the same notebook, except with Vista (a big negative) and a Celeron processor (an even bigger negative, especially coupled with Vista). If I wanted something with a Core 2 Duo, it would cost me about $1090, albeit the process is at 2.4GHz. Adding in another $90 will get a legal downgrade to Windows XP.

In other words, the price for me to get a system that is roughly identical (with the exception of being about 33% faster for number-crunching) to the one I am using currently will cost me about 40% today than it would have a year ago.

What the heck has happened? Normally I am very used to seeing computer prices decreasing over time, especially over a one year time-frame.

I’m not sure what’s happening in the land of computer economics. Are retailers (e.g. Dell), or the hardware markers (e.g. Intel) making larger margins?