Real Estate Investment Trusts for Income and Diversification

Income trusts are quickly disappearing due to the tax change announced by the federal government in 2006 whereby they will be taxed like corporations as of January 2011. However that tax change will not apply to one sector within income trusts - qualifying REITs (Real Estate Investment Trusts). REITs will thus continue to exist and they will continue to be able to pass through distributions free of tax to be taxed in the hands of the investor. This means higher distributions can continue to flow through to investors who will have no income tax to pay if the REITs are held within a registered account (unless and until a withdrawal is made from the registered account per the usual rules).

What is a REIT?
A real estate investment trust is a collective fund that pools the capital of investors to invest in various forms of real estate, usually income producing assets like apartments, shopping centers, offices, nursing/retirement homes and hotels that are structured to generate regular distributions of cash. REITs actively manage real estate assets.

Key Features:

• a form of equity - distributions are not guaranteed like debt, hence riskier
• frequent (often monthly) and substantial cash distributions - useful to investors for regular income
• traded on a stock exchange but are called units not shares and are distinguishable by the addition of the suffix UN to the symbol, e.g. CWT.UN

Resource: Though now outdated on the state of individual REITs, Deloitte's 8th Edition REIT Guide describes in detail how they work and how to assess them.

Why have REITs in a portfolio?

• Diversification -REITs tend not to move with the overall stock market, which reduces the volatility of a portfolio; see links to tables of correlation coefficients on Bylo Selhi
• Attractive Yields of 5% to 11+% - This table from Investcom.com shows a sample of REITs and their yields as of June 23

That's not the end of the story, however, since cash distributions can be and might be suspended or reduced. Globe and Mail columnist Fabrice Taylor recently expressed skepticism of current value in It's getting harder to see the value in REITs.

What are the risks to distributions?

1. Payouts too high to sustain the business' underlying needs to service debt and make capital expenditure re-investments. REITs may pay out 50-90% of profits on an on-going basis; when it is over 100%, watch out, that will deplete the business if more than temporary or short-term. Some businesses grow their distributions, they are not just stagnant "cash cows" though most of the expected return will be distributions, not gains on the unit price.
2. Leverage - if the underlying business has a lot of debt relative to revenue, downturns can be fatal.
3. Rising interest rates - can damage two ways: a) the underlying business runs into debt servicing problems and b) the fund units lose value since the distribution is less competitive with other sources of regular income like bonds; though the distribution may not decline, its value is less.

Resource: Bond rating agency DBRS has just published a financial profile with key data about leverage and its judgment on the sustainability of distributions of 13 major REITs. Standard & Poor's also provides ratings for some REITs under the Funds A-Z link.

Where to find REITs

• Investcom.com - Comprehensive listing of 34 Canadian REITs, shows their distribution yield and whether it has recently gone up, down or stayed the same as well as news and links to background reports and books
• ETFs - REIT Sector Index Fund (XRE) and BMO Equal Weights Index ETF (ZRE). There are also ETFs available through US exchanges for US and international REITs (see list on Stock Encyclopedia), though the distributions from these are not tax-advantaged as they are from Canadian REITs
• Mutual Funds - Use GlobeFund's filter set to Real Estate Equity to find funds that invest in REITs
  

DisclaimerThis post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Coping with an Uncertain Investment Time Horizon

“NOBODY expects the Spanish Inquisition! Our chief weapon is surprise...surprise and fear...fear and surprise" - Monty Python TV show (quote found on Thinkexist.com)

Life is full of surprises. Everyone knows that but it is sometimes forgotten by investors, for instance when younger people decide to buy only stocks given the fact that stocks provide higher returns in the long run than bonds or treasury bills and that a young person has a long time to go before retirement.

The flaws in this thinking arise from several realities. First, retirement is by no means the only investment objective. Major future spending may be anticipated for education of self or children, house purchase, travel, sabbaticals and gifts. So there are multiple objectives to consider, all with different time horizons. And that is only the stuff which is anticipated.

Then there are the surprises, both good and bad, that life springs upon us for which we may need or want to cash in the investments. Some of the surprises, such as a job loss or health problems, may also be dealt with through buying insurance, but others may require delving into one's portfolio. A marriage can be a wonderful unexpected event that arises quite quickly. An untimely death can bring on hefty funeral and burial expenses or need to support survivors. People intending to leave gifts in their will may decide that some circumstance compels giving the money immediately. Involvement in a lawsuit may entail big legal bills. The list can be long.

The problem with stocks, the flipside to the higher returns of stocks, is that there are considerable ups and downs and sometimes lengthy periods of ten years or more during which prices lag. Recent history - the 2001 tech crash and the 2008 credit crisis - is a harsh reminder of that reality.

A 30% decline in the stock market means that much less money available to spend at that moment. It is difficult enough to save so no one wants to be faced having to cash in after a 30% decline. What can the investor do to protect against such losses and yet maintain the flexibility in a portfolio to cope with unanticipated spending needs?

Diversify - Include other types of assets within the portfolio that typically do not move in tandem with stocks. The list of such asset classes comprises REITs, commodities, bonds and cash, especially the latter two. Bonds held their value very well through the 2008 crisis as we showed in our previous post The 2008 Crash - Case Study in Diversification and generally add a lot of stability to a portfolio.

Cash is inherently ultra-stable. Cash as an asset class for investors means more than just cash in a bank account. It includes highly secure (i.e. government and corporate top investment grade), short-term (no more than five years), easily- and quickly-cashed securities:

• Canada and Provincial Savings Bonds
• Cashable GICs
• Term Deposits
  
• Money Market Funds
• Treasury bills
• Commercial Paper
• Government and Corporate Bonds with less than 5 years to maturity

Ways to Buy
Our previous post Investment Building Blocks - Securities outlined how these products can be bought either individually or in various types of funds. Fiscal Agents publishes current rates for Cashable GICs and Term Deposits. Canada Savings Bond rates are here - note that they are only sold in annual campaigns and the next one begins in October. Contact your online broker for actual prices and to buy any of these for your portfolio.

How Much Allocation in the Portfolio
The Norm - The figure most often seen for an allocation to Cash is 5-10% of the portfolio. The recommended allocation to Bonds varies hugely - up to 75% of of the total portfolio, but it is rarely below 20%. Our previous post on Asset Allocation discusses the process of developing an allocation and includes links to tools for doing it.

Scenarios - Since everyone's life differs, one way to approach the decision is to look at your own particular situation and do a rough scenario analysis to guess what types of events could arise. Then estimate what those would cost and maintain at least that amount of your portfolio in Bonds and Cash. Doing a "perfect storm" combination of several simultaneous events adds a margin of safety.

All this is to say, beware of getting caught in a "Monty Python" event and have a margin of safety and flexibility in your portfolio.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Five Essential Books for the Canadian Investor

There is so much information available on the Internet that sometimes the online investor can feel overwhelmed and confused. Books can reduce that feeling by providing a complete package, an end-to-end integrated account of a subject.

The following books have in common a number of good qualities:

1. A very practical orientation, mixing a modicum of principle and theory with a lot of specific "what" and "how to" information presented attractively along with helpful tables and graphics.
   
2. All are short and to the point.
   
3. All are written by and for Canadian investors with Canadian examples and data.
   
4. All the authors take an unbiased point of view from the consumer/investor's perspective, giving warnings about products that they consider to be poor value, though of course they focus mostly on the good and the positive things to do and products to consider.
5. All give quite mainstream advice supported by research and facts, no wild get-rich-quick methods, no high-risk unproven schemes are to be found in these tomes.
   

General Investing
1. What Kind of Investor Are You? by Richard Deaves, published 2006

All the basics - interest rates, risk, mutual funds, ETFs, stocks, bonds, indexes, portfolio construction, DIY vs advisor, retirement, sample portfolios, unique content is investing psychology, review by CanadianFinancialDIY

2. No Hype - The Straight Goods on Investing Your Money by Gail Bebee, published 2008

Same basics as Deaves book, its unique content is coverage of a greater range of types of investments, some basics of registered plans (RRSPs etc) and taxes published 2008, reviewed by Canadian Capitalist

Taxes
3. Tax Planning for You and Your Family 2010 by KPMG

Updated every year, by a professional tax firm, gives the rules in clear, precise language understandable to the layman, with references to CRA plus tax saving tips on every topic.

Retirement
4. New Rules of Retirement by Warren MacKenzie and Ken Hawkins, published 2008

How to estimate income needs, assess and manage retirement risks, create and manage an investment portfolio, successfully DIY or use an advisor, reviewed by Retirement Action

ETFs
5. The New Investment Frontier III by Howard J. Atkinson and Donna Green, published 2005

More for the intermediate or higher level investor who really wants to know how ETFs work, reviewed by CanadianFinancialDIY

With the summer and holidays coming up, books are easy to toss into a bag to bring along and read wherever one happens to be and whenever there is an opportune moment. Happy reading!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Twelve Ultimate Buy and Hold Canadian Stocks

We are so accustomed to seeing companies rise and fall, often spectacularly so within a few short years, with disappointing or disastrous effects upon investors, that it is worthwhile to take another, perhaps more encouraging look at companies which have prospered through many years to the benefit of shareholders.

As we noted before in a comparison of so-called blue chip stocks in 1995 with 2009, corporate mortality rates are high. That has always been the case. There are very few companies around today in more or less their original name and form whose existence spans even a hundred years. The list of centenarians includes:

• 1891 Great West Lifeco (symbol: GWO), Dividend Yield 4.9%
  
• 1882 George Weston (WN), Yield 1.9%
  
• 1881 Canadian Pacific Railway (CP), Yield 1.8%
• 1880 Imperial Oil (IMO), Yield 1.1%
• 1880 Bell Canada Enterprises (BCE), Yield 5.5%
• 1867 Canadian Imperial Bank of Commerce (CM), Yield 4.8%
• 1864 Royal Bank of Canada (RY), Yield 3.7%
  
• 1855 Toronto-Dominion Bank (TD) - technically formed in 1955 but we'll count it since the two banks that merged to form TD both qualify, namely, the Bank of Toronto (1855) and the Dominion Bank (1869), Yield 3.4%
• 1859 National Bank of Canada (NA), Yield 4.3%
  
• 1832 Bank of Nova Scotia (BNS), Yield 3.8%
• 1817 Bank of Montreal (BMO), Yield 4.4%
• 1770 North West Company (NWF.UN), with a history going back to 1668; Yield 7.2%
  

Survival of the fittest is a term that certainly applies to this venerable group. They have survived and they are fit. Unlike most human centenarians who slow down in old age, these companies have been providing above average returns to their investors in recent times. For most of these companies, the results are outstanding. Look at the two MSN Money charts below which graph the market price of these stocks against the TSX Composite from 1997 to today. Not one has done worse than the TSX and several are hundreds of percent ahead (e.g. try out Royal Bank's historical returns calculator). To top it off, the charts do not include return from the steady dividend flow (NMF-UN's dividend payments are shown by the series of "D" symbols on its line), which for most of these companies is much above the TSX average, currently at 2.76%.




It is fascinating that the oldest company of the lot - North West Company - is the all star with the highest stock appreciation since 1997 - over 400%! - and a stream of dividends as regular as clockwork, not to mention a yield a big leap ahead of any other company in this list. The North West Company is familiar to any Canadian history student as the competitor in the fur trade to the Hudson's Bay Company, with which it merged in 1821 and spent the next 166 years until an employee buyout in 1987 (see Wikipedia article). NWF.UN still has a division trading furs and a logo of a canoe full of voyageurs - how's that for a business that sticks to its knitting?

It has not departed much from its roots in the north (though it now has operations in a number of other countries) and still touts its pioneering spirit and culture as frontier retailer. Its remarkable lengthy survival is made all the more amazing by the handsome rewards it continues to provide shareholders, a compound annual return of 25.8% over the past ten years. North West recently announced that it is converting from an income trust structure to a corporation with the intent to give off the same after-tax yield - about 4% - to a taxable investor as it does now.

And yet, this fantastic track record seems to garner the companies no respect. TD Securities rates NWF.UN as "Hold" and CIBC as "Outperform". (Canadians are known for understatement but this may be the understatement of the last 300 years.) This June 3, 2010 list of Canadian Stocks with the Highest Upside Potential ranks North West number 647 out of 694 with 0% upside potential. The highest rated centenarian is National Bank in 453rd spot.

The Future - Past Performance is No Guarantee
It is oft repeated, for good reason, that past results mean little. If a company makes poor decisions, or is in a declining industry, it will soon find itself in the dustbin of history. Selecting only the winners, as we have done, biases the results. One only has to remember the painful demise of Nortel, a company whose roots extended back to the 19th century. Canada's biggest banks, all members of this list, seem to have weathered the latest threat of the global financial crisis intact, but will they do well in a new world that is very likely to see more regulation and restriction on banks. Will North West's recent expansion out of North America prove successful? These questions require due diligence investigation by the investor.

Nevertheless, it is intriguing to consider this collection of stock winners as the ultimate buy and hold stock portfolio.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Which Way is Best to Invest in Real Return Bonds - Direct, ETF or Mutual Fund?

In our last post, we examined how real return or inflation-protected bonds can be a boon to retired investors looking for a steady income using a ladder (a series of bonds with staggered years to maturity) of five Government of Canada bonds. But we did not compare the ladder with the two other vehicles available to online investors to do so - ETFs and mutual funds. This post looks at the advantages and disadvantages of the three choices.

The Range of Choices
Real Return Bonds - The most readily available and the most secure bonds are those of the Canadian federal government, issued in five separate series, all maturing on December 1st of years spaced 5 years apart and paying semi-annual interest June 1st and December 1st:

• 2021 maturity - 4.25% coupon (see previous blog post for difference between yield and coupon rate)
  
• 2026 - 4.25%
• 2031 - 4.0%
• 2036 - 3.0%
• 2041 - 2.0%

As well, there are a handful of bonds issued by the Provinces of Quebec, Ontario and Manitoba. All are dated December 1st and make semi-annual payments June 1st and December 1st. Due to slightly higher risk, they provide slightly higher yield.

• Quebec: 2013 - 3.3%; 2021 - 4.5%, 2026 - 4.5%
• Ontario: 2036 - 2.0%
• Manitoba: 2013 - 1.753%, 2018 - 1.738%

ETFs - There are only two in Canada, one announced by BMO Financial Group only this past week.

• iShares DEX Real Return Bond Index Fund ( symbol: XRB) - launched in 2005
• BMO Real Return Bond Index (ZRR)

Mutual Funds - A search using GlobeFund (in the Fund Filter, under Asset Class, scroll down and choose Canadian Inflation Protected Fixed Income) brings up 19 funds, including the two ETFs. Several companies have multiple classes of units to buy depending on whether advisors are involved (usually F class) or direct arrangements are made for very large purchases (like SEI O class). Ignore them. For individual investors doing their own investing online, it is the A or D class funds to buy. That means 10 real return funds to choose from.

How the Choices Stack Up - Pros and Cons
The comparison table below sets out the characteristics of each choice, which we assess as follows. The chart highlights in green the points where one choice seems to be superior. But be careful, the amount of green doesn't necessarily add up and indicate the best choice overall. Read on to find why and then make up your own mind.


MER (Management Expense Ratio) and Net Investor Return - The annual deduction of fees by the ETF or mutual fund company is a critical factor. Why? The MER means a direct reduction in the net return for the investor. The lower MER, the better. When you buy RRBs directly, there is a one-time commission of around 1% embedded in the price charged by the broker selling you the bond, but when spread over the life of a 20 or 30 year bond, the cost per year can be tiny.

Particularly for RRBs, where the total universe of bonds is very limited and there is not a great deal of trading to do in a fund to rebalance or track an index, a buy-and-hold-to-maturity investor, like the retiree in our previous post, gains an appreciable net return advantage from buying bonds directly. MER is especially significant nowadays when RRB yields are 1.5% or less. Funds with MERs above that will produce a net loss for the investor. (The only way that could be countered is through a rise in RRB prices. How likely is it that bond prices will rise further, aka real yields will fall further, from their current all-time low levels?)

Against the big return advantage of direct purchases must be weighed the various other factors, some of which might be important enough for an investor.

Availability to Buy - Some days you might call your broker to find that there is no inventory of certain bonds or maturities available to buy. It might take some days or weeks to fill out a ladder of bonds. By contrast, the fund companies all have the ladder in place and you just need to buy shares or units at any time on any day.

Purchase Commission / Loads - Direct bond purchases incur a 1% or so commission embedded in the bond price. ETFs incur a trading commission which becomes cheaper in percentage terms the bigger the purchase. Mutual funds may have an upfront load fee, though the PH&N Inflation-Linked Fund highlighted in the chart has no fee.

Interest Income Frequency - Though all the RRBs within funds pay out interest only semi-annually, some of the funds distribute cash more often on a quarterly basis. These more frequent cash flows may be helpful to some people to match their income flow with their spending.

Interest Income Predictability - Directly purchased bonds will give off a highly predictable income stream that will rise steadily with CPI inflation. Fund cash distributions per share or unit will vary, sometimes considerably, due to the buying and selling within funds that changes the portfolio composition. For instance, iShares XRB cash distributions went up 21% from Q2 to Q4 in 2008 and then back down 24% in Q2 2009. That kind of bouncing around ill serves the retired investor seeking a stable income stream with predictable purchasing power. Funds compare poorly to direct purchases on this factor.

Drawdown Capital for Income - The ability to take out part of the capital invested, as opposed to receiving only the interest income, may be significant to some retirees. Having to sell off portions of directly held bonds becomes quite expensive due to recurring commissions and requires time and effort to plan. In addition, the balance of the ladder will be disrupted. By contrast, mutual funds routinely set up so-called systematic withdrawal plans for investors to take out regular payments at no extra cost. ETFs sit in the middle, with trading commissions and no automatic withdrawal plan, but the withdrawal through selling some shares can be of any size desired and the bond portfolio balance never gets out of whack.

Interest Distribution Reinvestment - For those who do not need to spend the interest income and want it reinvested in more bonds, mutual funds easily and routinely will reinvest the interest at no extra cost. Our two ETFs differ - the new ZRR fund will reinvest interest for the investor if desired but with XRB there is no automatic plan to do that and the only way to reinvest is to buy more shares on the market, which probably will work out to a fairly high percentage cost of reinvesting (e.g. a $10 commission to reinvest $500 of interest is a 2% cost).

Diversification - Since default risk with Canadian government and most provincial government bonds is pretty low, the main reason for holding a variety of RRBs is to mitigate the risk that interest rates will shift unfavourably at the time when a particular bond issue matures and that consequently reinvestment must take place on poor terms. This may not even be a concern at all if a retired investor intends to spend the capital when a bond matures. All the various fund versions provide the best available diversification through a variety of staggered bond maturity dates using the limited number of bonds on the market.

Purchase Minimum - This factor would most likely interest those pre-retirement investors who are at the early stages of building a portfolio and want to make small or regular purchases, as opposed to a retired investor wishing to build an appreciable income stream through large lump sum purchases. As we showed in the previous blog, it takes a hefty total to buy enough RRBs for significant income, such that even a minimum purchase size of $5000 would not be an impediment.

Reinvestment at Maturity - When a bond matures, a person holding a bond directly must then buy a new bond to stay invested, a bit of work and subject to interest rate risk as described above. With any of the funds, there is nothing the investor need do as the fund handles reinvestments and the fund itself never matures.

Portfolio Rebalancing - One of the basic principles of investing is to set target allocations for each asset class (see previous Asset Allocation post). This should include RRBs within fixed income. With direct bond holdings, this process would be awkward and imprecise due to the necessity to buy or sell bonds in multiples of $1000 face value along with having to choose which bond to buy or sell. The 1% commissions also add to costs. With funds, the amount bought or sold can be exact at no (mutual funds) or low (ETF) cost and the bond mix remains unchanged because it is always within the fund. For a retired investor seeking dependable known cash flow, the asset allocation target may take a back seat so this factor may not be too important.

My Bottom Line View:

• Direct bond purchases are best for retirees or others seeking the highest return and most stable income cash flow
• BMO's new ETF (ZRR) offers a credible alternative with its low MER and automatic free distribution reinvestment for investors building up a portfolio who can make large enough purchases to minimize trading costs
• Mutual funds like PH&N's with reasonably low MER and automatic everything may suit for investors needing to progressively withdraw capital or for those wanting to make small regular purchases to build a portfolio
  

Hopefully, the above look into the details of the options for buying real return bonds provides enough practical information for you the investor to choose the best option for your circumstances.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.