The Retired Investor - Real Return Bonds for Essential Living Expenses

Prior to retirement during the accumulation phase of investing, the main consideration for selecting investment assets and setting each one's target percentage of the portfolio is the optimal mix of return and risk characteristics, in other words to make the most money with the lowest risk.

When retirement starts and income withdrawals are required from the portfolio, it is important to align the portfolio with income needs in terms of:

• income amount
• regularity of payments
• reliability of the income stream relative to the need for the income
  
• special financial risks during retirement
  

Real return bonds (RRBs) are bonds issued by governments whose interest payments and principal are continually adjusted to keep pace with inflation. RRBs are very useful to retirees to pay for the most essential, basic living expenses for several reasons:

1. Government guarantee - It may be disappointing if you lose your holiday money but losing your grocery or heating bill money is calamitous. The Government of Canada has the highest possible credit rating of triple A so you get the most assurance that the money, both interest and principal, will be paid, will not be defaulted and will not be delayed. The guarantee is doubly important considering the next factor, how long the bonds will be outstanding.
   
2. Long-lived investment - Current RRBs have maturity dates (the date when the money will be paid back to you the investor) extending as far out as 31 years to 2041. Since retirement can easily last 30 years nowadays with better health and increasing longevity, such long maturities can be very helpful by matching time horizon of the investment with the retiree's life. Putting in place reliable investments like RRBs that do not need to be monitored are an additional convenience feature.
3. Inflation protection - Inflation is one of the most surreptitious and pernicious wealth destroyers in the long term. Even the current Bank of Canada target 2% inflation rate will steadily and drastically reduce buying power over many years. Retirees can much less afford to lose their purchasing power since they cannot necessarily go back to work. RRBs are adjusted for inflation according to the CPI, which is as good a gauge of inflation for seniors as everyone else according to CanadianFinancialDIY.
4. Capital preservation - As a bonus, the guarantee and the inflation-protection of RRBs enable retirees to set aside a legacy of real value if they wish to do so.

How to Use RRBs to Fund Essential Living Expenses
Step 1 - Budget: estimate spending for your most essential needs on an annual basis
Step 2 - Other Income: Add up other sources of equally reliable inflation-indexed income, notably CPP (current maximum payment is $11,210 per year), OAS (about $6,200 per year) and any defined benefit pensions. Subtract that from your needs to see what amount would need to come from the investment portfolio after tax.
Step 3 - Taxes: If the income will be coming out of a registered account as is suggested below, estimate the pre-tax income required by adding back an amount for income taxes. Take your marginal tax rate when retired (see tables by province at Taxtips.ca) - many middle income brackets are in the 30-40% range - and add it back e.g. to get $1000 after-tax at a 30% rate, you will need $1000/(1-0.3) = $1428.57 pre-tax.
Step 4 - RRB Income: Create a spreadsheet like the one below to figure out how much to buy of various potential RRBs to produce the required income. Essential inputs are:

• Prices and coupon rates for the various RRBs, obtained by phoning your discount broker. There are currently only five issues of RRBs by the federal government, all maturing on December 1st and paying interest twice yearly on Dec. 1st and June 1st. The maturities are 2021, 2026, 2031, 2036 and 2041. Only Quebec and Manitoba issue RRBs and their returns are higher, though of course that comes with slightly less sure guarantees.
• Index Ratios for each bond - updated every month on this page by the Bank of Canada.

With those two inputs, it is possible to figure out exactly what an individual RBB, or combination of several in a bond ladder, will pay in interest today. Forever thereafter till maturity, the RRB will pay exactly the same amount adjusted for inflation.


In the example, the target income amount is $6000 per year. It is obtained by plugging numbers of purchases of the face amount of bonds (the cells in yellow), which are sold in multiples of $1000, typically with a $5000 minimum. The real yield column - the discount broker will tell you this number when they quote the price - tells us that three issues, the 2031, 2036, 2041 bonds have better yields or returns than the shorter maturities, which is why bigger amounts have been placed into these issues in the example. Note how the current inflation-indexed principal value of the bonds at $184,821 is much lower than the total price today required to buy them, $250,146. The reason is that you will receive much more interest over the life of the bond than the going rate, which is the real yield. To compensate for this, the price is higher.

When the 2021 bond matures, the principal will be paid back to the investor and the $591 in semi-annual interest will stop. The investor will have a choice to repurchase other new RRB issues to gain interest or to buy shorter term GICs, T-bills, money-market funds or keep the money in cash to fund living expenses, where the inflation effects will not be as harmful for the short term. If the principal of maturing bonds is used for spending, the income level can rise substantially - as the table below shows, from 2041 to 2046, the pre-tax annual income from spending the capital of the last bond is $11,225. Would you want to spend it all at that point, and not re-invest any, considering that after 2046 there would be no money left?


Caveats and Limitations

• Low current yields - In line with low interest rates currently on offer from all types of bonds, the real yield or return on RRBs is under 2%. This is as low as such rates have ever been and real interest rates have been trending downwards for a good twenty years as a graph on this post by CanadianFinancialDIY shows. No one expects real rates to rise much, but if one locks in today for the long term, the price has been paid. Higher real yield would mean that the same income stream could be bought for considerably less. As the spreadsheet shows, it costs a hefty $250,000 today to lock in a guaranteed inflation-protected $6,000 annual income stream. Nevertheless, if the purpose is to lock in essential retirement income and one has the cash to fund it and gain the peace of mind, then why would one wait, perhaps for years, in the hope of higher yield? It is a trade-off the investor has to make.
  
• Low returns / yields as a matter of course - On top of the current situation, one should expect that highly secure investments will always produce lower returns. Add in the extremely valuable inflation protection, it should be no surprise that yields and returns will always be on the low end. RRBs are not for growth in assets nor for getting rich; they are more about preserving income, wealth and purchasing power.
  
• Ladder five year intervals - It would be much easier to plan the cash flows if RRBs existed at more frequent intervals than five years apart.
  
• Ordinary long maturity government bonds might have a better payoff - There are equally secure government bonds paying higher interest rates but they are not inflation-adjusted. If inflation is low, below about 2.2% per year, such bonds will give a better return than RRBs. Above that inflation rate, RRBs win. How much you do not want to worry about inflation is a key question with RRBs.
  
• Suitable only for registered accounts - Due to tax rules that make the inflation component of the principal subject to annual tax if held outside a registered account even though the inflation payment is only made at maturity with return of the par value, it really only is feasible to hold RRBs within a RRSP, RRIF, TFSA, LRIF or other such tax-deferred account (see the Bank of Canada's About Real Return Bonds).
• Disposition before maturity may cause capital loss - If real interest rates were to rise, the usual fall in price of bonds in that circumstance would also affect RRBs and a forced sale before maturity, for example on death of a retiree, might result in a capital loss.
  

It is also possible to buy Canadian RRBs through ETFs or mutual funds. Another post will compare the pros and cons of these methods vs individual direct purchase.

The unique combination of features possessed by RRBs makes them very worthy of consideration in a retiree's 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.

Taking Advantage of Value Stocks

A few posts back, we discussed how researchers Eugene Fama and Kenneth French found that small cap stocks over long periods provide higher returns to an investor than both the overall market average or the large cap stocks, such as the S&P 500 or the TSX 60. The famous "Three-Factor" paper in which they published these results also revealed that Value stocks present attractive properties for an investor.

What is a Value stock?
Any stock whose market price is low compared to some fundamental accounting measure such as book value, earnings, dividends, sales or cash flow is a Value stock. Value stocks are distinguished from their opposite, Growth stocks. The simplest classification, and the one used by Fama and French to describe the Value effect, is based on Price to Book Value. As with small companies, different index providers use different measures or combinations thereof to put stocks into the Value or Growth category. MoneyChimp's Index Styles page tells how the main index providers like Morningstar, Russell, MSCI Barra and Standard and Poors identify the Value stocks (see CanadianFinancialDIY's comparison and opinion on which Value index is best).

Why would Value Stocks interest an investor? Whichever index is used, the same benefits described below, more or less, are observed. It is worthwhile to note that the Value stock benefits also hold in different countries and markets (see William Bernstein's discussion of the Fama French findings and his assessment of actual US and international Value fund performance; another good source is the book All About Asset Allocation by Richard Ferri).

1. Higher returns - Over a long holding period of twenty years or more, Value returns significantly outpace - by 1% up to 4 or 5% annually - Growth and the overall market average. The effect is more pronounced among small companies than large ones. Another MoneyChimp page called Building Portfolios has a couple of simple calculators where a click will show the past performance results of Value vs Growth for large and small caps in the USA. It is essential to note that Value out-performance reliably occurs over long periods. Sometimes Growth stocks go on a run for multiple years beating out Value.
2. Non-correlation with the overall market - Value stocks do not move in tandem (i.e. are not correlated) with the total stock market average. Putting Value stocks into a portfolio with total market funds and other non-correlated assets like bonds and REITs lowers the volatility /risk of the overall portfolio.

Ways to Invest in Value Stocks

• ETFs for US and International Stocks - A couple of dozen choices can be found in the listing of Value Stock ETFs in Stock-Encyclopedia. For those who wish to combine the Small Cap and Value effect benefit, there are several Small Cap Value ETFs. Amongst the PowerShares International ETFs are a number of RAFI index funds, which use a form of value selection. There are ETFs for Europe (Symbol: PEF), Developed Markets excluding the USA (PXF), Developed Markets ex-USA Small and Mid-Cap (PDN), Emerging Markets (PXH) and even for Japan by itself (PJO).
  
• ETFs in Canada - There are two choices: iShares S&P/TSX Value Index ETF (XCV) and Claymore Canadian Fundamental Index ETF (CRQ).
  
• Mutual Funds - Hundreds of Value funds are available in Canada, covering both Canadian and US companies. To find them, go to GlobeFund's Fund Selector page, then in the box Option C / Name type in Value. It will be necessary to wade through the funds one by one to see exactly what criteria each fund uses - usually it is stated in the fund objectives - to determine value. Such mutual funds will go beyond using only fundamental ratios to pick what they consider to be value stocks and will analyze many aspects of each company to try to get superior returns, though only some succeed as the majority do not.
  
• Individual companies - Use a stock filter such as the Globe Investor Stock Filter (note that discount brokers such as BMO Investorline also typically have such a tool within their website) to select companies. Type in a maximum price/book value or price to earnings per share e.g. 1 for P/B and 12 for P/E and run the search. Click the Financial and Ratios tabs to see the numbers and click on the P/B column heading to sort low to high. The stock filter then also allows you to start narrowing the possible investment targets using other fundamental factors like net profits, sales growth, debt level etc. Listing the holdings of ETFs, which are all publicly available on their websites, is a quick way to find reasonably actively traded Value companies since the ETFs usually exclude companies with too little stock trading.

As their name suggests, Value stocks, in whatever form, can be a valuable addition to an investment 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.

The Stock Market "Crashes" (Again) - What to Do?

Last week's stock market declines due to nervousness about the faltering finances and social unrest in Greece prompted news writers to trot out scary words like contagion, default, domino effect, rattled, catastrophe, abyss. Individual investors may feel rising nervousness and worry as to whether another crash as severe as the 2008 sub-prime meltdown is about to unfold. What to do and how to react is the question of the day.

Recognize, Channel and Control Emotions - We humans are not just rational machines. Threats to our well being, financial as well as physical, provoke instinctive fear and flight responses that crowd out our ability to think straight. Step 1 is to be aware of this reality. Markets are not disembodied beings but the collection of humans who trade. Institutional investors are people too and just as prone to emotional reaction. The net result is that markets can get carried away and over-react downwards out of fear. The negative consequences of Greece's problems and possible ricochet effects on other countries may be real, but overdone. Our objective is not to try to ignore our emotional reaction since it will only fester and since it may signal a real threat we should deal with. Our goal is instead to avoid the reactive response - usually to sell in a panic - and to harness our rational self as a second opinion for a considered response.

Control Techniques

• Develop a written investment policy and plan - having a plan such as described previously in a Written Investment Policy itself provides a psychological barrier to too-quick action. Your plan will, or should, take into account that stock markets are volatile and downturns, often significant, do occur. Explicitly envisage a downturn and think what you will do. Better yet, write down what you will do as that will help cement your commitment to actually follow the plan.
  
• Create distance between yourself and the event - Sleep on it, defer a decision till tomorrow, go do something pleasant for a few hours, write down your feelings about the crash. Even something as seemingly silly as pushing yourself physically away from the keyboard apparently helps objectify the market event and allow you to deal with it with a cooler head. Ask yourself what someone else would do, or what you would do if you were managing someone else's investments. A tremendous book that talks about the effect of emotions and such techniques is Jason Zweig's Your Money and Your Brain.

Analyze the Threat - When the emotions have been calmed, it is possible to examine an event like a possible Greek sovereign debt default. Here are some factors to consider:

• Sovereign debt defaults are nothing new, and seem to happen in cycles, as Carmen Reinhart explains in Eight Hundred Years of Financial Folly at Vox EU.
  
• The 1997 Asian Financial Crisis (see summary on Wikipedia) was the last big crisis that caused fears of global financial meltdown. There was contagion to several countries. Though each crisis is unique and Greece could be different, note the size of the stock market "crash" through 1997 and 1998 in this Google Finance chart of the S&P 500. It looks quite small compared to the 2000 tech bubble bursting and the 2008 sub-prime crash.
• 
• 1998 also witnessed Russia defaulting on its debt and the collapse of gigantic hedge fund LTCM, prompting more concerns of financial meltdown. The lesson is that crises have occurred often in the past and the financial world has not imploded. There are options available and suggestions for arresting the Greek crisis from spreading to Spain, Ireland, Portugal and other highly indebted countries (e.g. Barry Eichengreen's It is not too late for Europe). To anticipate that it will be different this time and that financial Armageddon is nigh, one must almost suppose that public authorities will mess up through wrong actions or inaction.

Look at the Impact from a Portfolio Perspective - Investors who diversify have experienced much less loss because the market drop has primarily affected Europe. For instance, the average return since January 1st of a portfolio with these holdings would see a modest decline:

• iShares S&P TSX Composite ETF (symbol: XIC) that tracks Canada's TSX - down 0.3%
• iShares DEX Universe Bond Index (XBB), a mixture of Canadian government and corporate bonds - up 0.2%
• Vanguard European Equity (VGK) - down 15.7%
• SPDR S&P 500 (SPY) - down 1.1%
  

The market downturn may not be over yet as either the reality of countries' debt problems worsens or a possible market over-reaction runs its course. Nevertheless, managing our own emotions and building better expectations will help us get through this latest market nastiness more successfully.

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.

"Small is Beautiful" - Also True for Investing

The famous and influential 1973 book Small is Beautiful by E.F. Schumacher (see Wikipedia summary) proposed a philosophy that small is good for economics and business. Though the book did not address investing, the title applies to investing as well. Two decades after the book appeared finance researchers Eugene Fama and Kenneth French published ground-breaking results (what is now called the Fama-French Three-Factor Model) which showed that smaller company stock returns outpaced those of large companies over long periods, though at the cost of higher volatility or risk.

What is a Small Company?
They are companies whose total stock market value or capitalization is at the bottom end - thus the term small cap. It is a relative term, where the dollar limit varies by different stock exchanges, mutual funds, ETFs and search tools. The TSX Small Cap Index sets a range of C$100 million to $1.5 billion in quoted market value. In the USA, one popular index is the S&P SmallCap 600, which sets a range of $250 million to $1.2 billion.

Higher Returns and Volatility of Small Companies
The charts below illustrate this reality using Google Finance charts of prices of US and Canadian ETFs that track the small cap sector.

1) Long Term Outperformance - Since June 2000, the small cap iShares S&P 600 Small Cap 600 Index ETF (symbol: IJR) has gained 87% while the total market iShares Dow Jones U.S. Total Market Index (IYY) has lost 10%.

That return advantage is not typical or sustainable over the very long term. Since the 1920s the excess return of small cap stocks in the USA vs large caps has been about 1.5% per year.

2) Volatility - During the recent financial crisis from mid 2007 onwards, small cap stocks in Canada, as measured by the iShares S&P/TSX Small Cap Index ETF (XCS) dropped significantly more than the overall market tracked by iShares Capped Composite Index ETF (XIC) and they still have not regained the lost ground.


Pros and Cons of Small Companies as Investments

• potential for faster growth that is often realized - large companies are so big they cannot and do not grow as quickly - thus the higher returns from small caps
• higher risk of business trouble - the counterpart of faster growth is a higher failure rate for individual companies
• much less tracking and analysis by professional and institutional investors or the business press, so less information is available about smaller companies. This in turn translates into both higher risk and more opportunity for individual investors to find mis-priced stocks.
  
• lesser trading volumes which can mean higher spreads between bid and ask prices and possibly illiquidity, where it is hard to buy or sell
• relatively uncorrelated with other asset classes, which can bring diversification benefit to a portfolio (for how this works and why it is important, see How to Diversify without "Diworsifying" and Asset Allocation: the Most Important Investment Decision You Will Make)
  

Ways to Invest in Small Caps

• ETFs in the USA - For US companies there are several dozen different choices - see the listing of Small Caps in Stock Encyclopedia
• ETF in Canada - For Canadian small companies there seems to be only one ETF at the moment: iShares S&P/TSX Small Cap Index ETF (XCS). ETFs are typically passive index trackers and simply mimic the market.
  
• Mutual Funds - Hundreds of funds are available in Canada, covering both Canadian and US companies. To find them, go to GlobeFund's Fund Selector page then in Option B Asset class pick the US or Canadian Small/Medium. Mutual funds almost always try to outperform the market through active stock selection though only some succeed as the majority do not.
  
• Individual companies - Use a stock filter such as the Glove Investor Stock Filter (note that discount brokers such as BMO Investorline also typically have such a tool within their website) to select small cap companies. Simply type in market cap size minimum and maximum limits (e.g. ones noted in the ETFs above) and run the search. The stock filter also allows you to start narrowing the possible investment targets using fundamental factors like net profits, sales growth, debt levels etc. Listing the holdings of ETFs, which are all publicly available on their websites, is also a quick way to find reasonably liquid small companies since the ETFs usually exclude companies with too little stock trading.

Portfolio Allocation: Authors like Richard Ferri in All About Asset Allocation and William Bengen in Conserving Client Portfolios During Retirement recommend that small companies make up 5% to 15% of a total portfolio depending on individual 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.