Sunday, September 22, 2013

Where this market stands – fixed income is the destroyer of wealth hidden below a mask of ‘low risk’

So we’re standing at the brink and looking out over an investment landscape of tapering and… rising interests. The world seems to move in giant cycles that stretch out over decades. Right now we’re are around a major turning point in the interest and inflation cycle – we’re moving from decades of falling interest rates and inflation to decades of rising inflation and interest rates. Will we peak again at 22% interest rates and 10% plus inflation 20 or 30 years from now?  I have no idea, I just think I am recognizing a change in trend.

I am not a fan of fixed interest instruments, and in this blog I have warned several times about investing in long term bonds. Fixed income is the destroyer of wealth hidden below the mask of ‘low risk’. So many fall for this questionable investment vehicle because they think that their capital is ‘save’. Nothing is farther from the truth. The only benefit that bonds and other fixed income instruments present is a low volatility instrument that during times of turmoil and uncertainty may rise in price against more volatile investments such as stocks. This has been illustrated many times during stock market crashes.
In fact, fixed income and gold have this characteristic in common. You may even go so far as stating that gold is acting like a coupon bond in that it does not pay interest but instead appreciates to its face value as the coupon approaches maturity. Gold does not mature but it is seen by many as a hedge against inflation. The coupon acts the same way as long as the coupon rate (interest rate) equals or exceeds the inflation rate. The logic behind all this is too intricate to discuss today but we’ll return to this topic in more detail in later blogs.
Let’s do some simple math to illustrate why fixed income instruments often destroy wealth. Say inflation is 4% (rather than today’s 1-2%) then for an investor to make real money the interest rate charged on borrowed money is a bit higher say 0.5 -1% for short term (6 month to 2 years) investments. The extra interest is called the ‘real interest rate’ or the rate at which the purchasing power of your money increases.  Increased uncertainty associated with lending money over longer and longer time intervals results in the real interest rates being higher for longer maturity loans.
Thus the interest rate charged on a loan equals the inflation rate plus the real interest rate. In our example that would be 4% inflation plus 1% real interest rate which equals 5%. Now comes the kicker: taxes! Let’s take Canada’s lowest marginal tax rate for a top bracket Canadian. That is Alberta’s marginal tax rate of 38.8%. An Albertan pays 38.8% tax over the 5% interest rate, thus on an after tax basis your return is 5% x (1-38.8%) = 3.06% Oops, but inflation is 4%, the lent money decreases in purchasing power or in real terms at a rate of 3.06-4 =- 0.96% per year. In today’s economy the numbers are worse. Because the interest rate is typically 1%, thus after tax you ‘earn’ money at a rate of 1%x (1-0.388) = 0.612% with inflation being 2% your real interest after tax is negative 1.39% Ouch!
The only place you can retain some profits on fixed income is not in your RRSP either, but in your TSFA.  Assuming tax rates will not change over the coming decades (I think they will increase) then unless you’re not saving a significant retirement fund, chances are that your current tax rate is lower than in your retirement. The advantage of a RRSP is that you do not pay income taxes over the money that you pay into the RRSP. The disadvantage is that you pay taxes when you take it out and you pay taxes over the investment gains you made. Thus you’re likely paying more taxes over the entire life of your investment than if you kept it outside the RRSP. Especially because you forego capital gains tax and dividend tax credits and you cannot deduct capital losses – and who makes only gains? Bottom line, you will pay the maximum tax rate over the interest you may have earned within your RRSP. Conclusion: You’re hoosed!
Thank the Conservative Government for introducing the Tax Free Savings Account because this is the only tax shelter where you can make at least a tiny bit of money on your interest income. But again, how would that compare with the typically much higher profits you’re making on real estate or stocks in that TSFA? You see the issue? I certainly hope so. At best, investing in fixed income is a preserver of capital and that is only true if you invest in a TSFA. There are better investments than fixed income that make a lot more profits on an after tax basis and that are even better within your TSFA.
Thus the three reasons we’re investing in fixed income is as a hedge against a stock market crash, for reduction of the overall volatility of your portfolio value and for temporarily parking cash (interest income is better than no income at all). You could try to increase your interest return by investing in junk bonds or in other lower grade debt, but that would often also increase the risk of default and losing your money.
There is another issue with lending money – appreciation and depreciation. If you lend someone, say the government of Canada using bonds, money ($100) that earns 5% you will earn $5.00 in interest per year. So now rates go up, say to 7% and a new bond of $100 would earn $7. How much would you pay for my $100 bond that earns only $5?  Right, less than $100, in fact a lot less, $71 to be precise. That means the 5% bond holder lost 29% of his money, unless… he doesn’t sell and waits until the bond expires and the government redeems the bond for its face value of $100.
When you buy bond ETFs, those bonds are often sold before they mature, i.e. they do not expire and are not repaid at face value. In a rising interest environment you are likely to lose money on such funds. If you want to hedge your portfolio against volatility or you want to temporarily park cash use 1 to 2 year Guaranteed Investment Certificates (GICs), short term treasury bills or plain savings accounts. You can buy bonds, say 1 to 2 year government, provincial or Canadian bank bonds at a rate you feel is good and hold on to expiry. Buying several bonds with different maturities say, 30 days, 6 months, 1 year and 2 years (i.e. a laddered approach) will reduce the risks resulting from rising interest even further.
Stock markets have risen significantly this year and we’re entering the last stage of a bull market. This stage may last a few months or another couple of years (wouldn’t that be nice). Therefor risk is increasing, the chance that the market will crash increases every day. Thus, we do not want to buy a lot more stocks (unless it is an extremely good deal) but rather let our profits run. Sometimes stock prices may go up so much that we may feel that they have reached their full value and some more. That is a time to consider the sale of those stocks; to build up cash and putting this cash in fixed income until the market crashes providing new investment opportunities.

 

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