Friday, 21 March 2014

Picking Countries with a Weak Currency - How did it perform?

About a year ago in Using Weak Currencies to Find Foreign Equity Investment Opportunity, we wrote about research findings that found that equities in countries which had experienced prolonged weakness in their currency subsequently performed much better than the average. We dug up the data and identified seven individual countries and the Euro area, all of whose currencies had taken a battering. Let's now see what happened. Did those countries' equity equity markets do well for a Canadian investor?

The Eight Weak Currency Countries of Last Year - Win big or lose big
Last year's post listed available ETFs for each country and the Euro area, so we simply went to the ETF provider's website to get the return performance. Then we adjusted the return for the fact that since many of the ETFs trade in US dollars on US exchanges, the fall in value of the Canadian dollar (CAD) against the US dollar (USD) boosted results for a Canadian investor (i.e. each USD bought more and more CAD over the year). In fact, the USD went from buying $1.0285 CAD to $1.1065 between 1st March 2013 and 28th February 2014, a 7.58% rise, which is what we added to the returns for each of the US quoted ETFs.

1) Euro area:

That's an outstanding return, far ahead of a benchmark such as one for all non-North American developed countries, which happens to have a heavy loading of Euro holdings, the EAFE (Europe, Australia, Asia and the Far East) ETF from iShares Canada, iShares MSCI EAFE IMI Index ETF (TSX symbol: XEM). XEM's return was also outstanding but considerably less at +29.3%.

2) Denmark:
That's amazing return (imagine the TSX rising that much in a year!) and far better than the EAFE benchmark.

3) India:
These slightly different funds gave slightly different results. However, it is worth noting that the total return of the Canadian quoted funds, taken directly from the provider website, ended up in the same ballpark, after the CAD vs USD return is taken into account, as for the US-quoted INDY, whose USD return was -2.47% before the currency return was added. This demonstrates what we have noted before - that the currency change that matters is not the USD in which the ETF is traded but the shift between CAD the relevant country currency.

Note also that this positive return handily exceeds the return from the average of Emerging market countries in a benchmark fund such as the iShares MSCI Emerging Markets ETF (NYSE: EEM), whose total return was +1.0%.

4) Brazil:
This is far worse than the EEM benchmark.

5) Indonesia:
This is also far worse than the EEM benchmark.

6) Poland:
Another EEM benchmark beater.

7) South Africa:
And another EEM benchmark beater.

8) Turkey:
This is another massive under-performer of the EEM benchmark.

That's five winners and three losers in the weak currency sweepstakes.

There was a correspondence between each country's currency performance and the equity returns. Clicking through each country's one-year currency Visualizations Market Map chart on RatesFX, those with depreciating currencies with lots of bright red, like Indonesia, Turkey and Brazil, had poor equity returns, while those with good equity returns, like the Euro (chart image below), Poland and Denmark, saw their currencies appreciate - lots of blue on the chart.
(click to enlarge)
India and South Africa's currencies had strong bright red depreciation with modest though benchmark-exceeding returns. Last year they evidently hadn't yet hit the bottom of the currency path. Maybe the strong returns are to come.

The latest weak currency countries
Going through the same scan of the latest three-year currency performance on RatesFX, the countries with the telltale red of depreciation are:

1) Japan - Performance of Japanese equities was excellent in the 12 months ending February 28th, aided by the weak currency for a Canadian investor - up 21.3% in the iShares MSCI Japan ETF (NYSE: EWJ). Perhaps after many years of stagnation, market returns will remain positive. The Credit Suisse study we cited last year found that superior equity returns subsequent to currency weakness could persist for years. The valuation metrics on EWJ's webpage are moderately attractive - a fairly high Price/Earnings of 19.3 and a low Price/Book of 1.7.

Other ETFs to invest in Japanese equities, all traded on US stock markets, are listed in the ETFdb. There is only one unleveraged Japan-only equity traded in Canada, the iShares Japan Fundamental Index Fund (CJP), which is CAD-hedged, a feature that isolates market moves from currency moves in the short term, though it does impose a significant drag on returns in the long term, as we discussed in this post.

2) Chile - The equity market, as tracked by the iShares MSCI Chile Capped ETF (NYSE: ECH), did very poorly in the last twelve months, returning a huge decline of 25.2% for a Canadian investor. EWJ's valuation metrics are only somewhat appealing with a high P/E of 22.8 and a low P/B of 2.0.

3) Canada! - Except for other countries, several noted above, whose currencies are even weaker, the CAD has a weak track 3-year record against all major currencies (chart below). Choices of ETFs to invest in Canadian equity are many - see our reviews of Canadian large cap equity ETFs and a comparison of Canadian low-volatility with cap-weight ETFs.
(click to enlarge)

Valuation metrics of the Canadian equity benchmark iShares S&P/TSX Capped Composite Index Fund (TSX: XIC) are quite reasonable - a P/E of 16.6 and P/B of 2.0. Perhaps good returns are in the offing for investors in Canada's equity market.

Bottom line: Like all long term statistical relationships determined across many countries and multiple years, the one where weak currency presages stronger equity equity returns doesn't work without fail in every instance and it hasn't worked in the past year for every currency/country, only a majority of five out of eight. It also seems to be a "win big or lose big" proposition.

As for implementing a strategy to exploit the weak currency phenomenon, our post last year noted what we think are steps in a prudent approach. In addition,To adopt such a strategy is probably not for everyone. The best option for most investors who don't wish to take the time and trouble to track, then buy and sell the individual country holdings, is to invest in a few broad index funds like the benchmarks above (or the best in each category - see our comparisons of Emerging Market equity ETFs and diversified Developed Country ETFs).

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.
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Thursday, 20 March 2014

Canadian ETFs with High After-Tax Cash Yields - Separating the Good from the Not so Good

Where does an investor find ETFs with a high after-tax cash payout? And what is the potential negative side of high payout funds, is there an Achilles heel? In general terms, the main potential negative is that a high payout may not be based on true investment return but merely be paying back the investor's own capital. Linked to this is the question of the likely future sustainability of the payout. What does the continued high payout depend on?

However, the first job is to find the funds. One place to start looking for such ETFs is a website like Best Dividend ETFs which posts a list of Dividend ETFs with Domicile in Canada that currently distribute a lot of cash. We've taken that list and added other funds that looked promising. Other promising funds can be unearthed by looking through the tax breakdown for the previous year that the ETF providers publish every year around this time for their own ETFs. The trick is to look for ETFs that have handed out tax efficient income, starting with return of capital (ROC), then dividends and capital gains. Interest income and foreign income are taxed at the highest marginal rate so those types of funds are less likely to distribute a lot after-tax.

To assess the best after-tax net return, we gathered data for ETF performance over the year 2013, incorporating three factors: i) the pre-tax payouts, ii) the tax breakdown of distributions as published by the ETF providers and iii) the tax rates that apply to return of capital, dividends, capital gains and foreign or interest income.

Today's post updates the review we did last year in two posts -   first, on the net returns in 2012 and second, on the likely sustainability of their high payouts. Redaders will note that many of the same high payout funds are on this year's list but that doesn't necessarily mean they are good choices.

The High After-Tax Payout ETFs
In the comparison table below, the results show how much cash return was received by an investor in the second highest Ontario tax bracket - $135,000 to $509,000 - or in a middle income bracket - $70,000 to $79,000 - in percent yield and in amount retained per dollar of cash received. There are some differences in ranking of the funds since higher rate taxpayers pay less tax on capital gains than on dividends while the reverse is the case for the middle income person, but the order is roughly the same.
(click on image to enlarge)


Many of the top payout funds in 2013 relied on bad Return of Capital (ROC) - The table highlights in red text the bad-ROC ETFs where the high tax efficiency and payout consists of large dollops of ROC and where the fund endured a net decline in Net Asset Value (NAV). As we have written in the past in the above linked posts and in the ever-popular Return of Capital: Separating the Good from the Bad, an ETF that merely pays an investor back his or her capital is not providing worthwhile performance.

Several other top payout funds have lost their advantaged edge - The grey shaded cells show the funds that last year lost their tax advantage when the federal government budget invalidated the transformation of interest income into capital gains by use of a forward agreement. Some funds ended the forward agreements later in 2013, like CVD, and others like CSD, CHB and HAF have adopted a transition strategy that uses the grandfathered existing forward agreement till expiry. Despite being allowed to continue for that limited time, their tax benefit will nevertheless be progressively diluted as new subscriptions enter the fund gaining normal interest that will be distributed as such to all shareholders old and new alike.

Call option revenue underlies a handful of high payout funds - Five funds - LXF, HEX, ZWU, ZWB and HEF - rely on revenue from writing covered calls on their portfolio holdings to generate tax efficient extra income for distribution to shareholders.

Call option revenue is treated as capital gains but several of the ETFs in the table have no capital gains but lots of ROC. BMO's ETF Taxation background document explains how this happens: "From a tax perspective, the gains from writing options are combined with gains and losses from trading the underlying portfolio. If the underlying portfolio trades have generated losses, these losses reduce or negate the tax gain from the written options and create ROC." When that occurs, the fund may only be distributing cash equal to the sum of call writing income and dividends, but the NAV capital loss portion from trading losses is bad ROC.

Rising markets are key for a couple of high payout funds - Two funds - FIE and XTR - pay out a pre-set steady stream of cash that is partly based on unrealized capital gains, and thus becomes return of capital, from increases in the market value of holdings. In years when markets decline the ROC will be bad and in up years like 2012 and 2013, the ROC will be good. Long term success depends on markets rising more than they fall over the years.

Dividend stock focus explains the last group of high payers - Our table of the top 15 best after-tax payouts contains three funds whose high cash distribution depends on a portfolio of stocks paying healthy dividends - ZDV, ZUT and XEI. The funds merely pay out what they generate.

Major Canadian Index ETFs are tax efficient for middle income investors but not nearly as much for high bracket earners - For comparison we compiled the same data for some of the most popular Canadian equity index ETFs. The first thing we note is that generally the net after-tax payouts are much more modest, in the 2- 3% range across both income tax brackets. But the tax efficiency in terms of amount of each pre-tax dollar retained after tax is much better for the middle income earner, around 86 cents on the dollar, than for a a high bracket investor. The index funds mainly pay out dividends, which are taxed less in the middle income investor's hands.
(click to enlarge)


There is not much difference in efficiency between the highest cash payout funds and the index funds for the middle income investor. There is a great deal more difference for the high income investor - 72 cents on the dollar retained from the index fund payout vs as much as 90+ cents. The high payout funds with high efficiency are a much more appealing proposition for high earners.

Sustainability of cash payouts is a challenge for most high payout funds - Our next comparison table calculates the gap between the payout rate and the amount of income the holdings generate in dividends or interest net of MER. We have highlighted in salmon colour those ETFs where there is a substantial shortfall that must be made up somehow to avoid paying out bad ROC.
(click to enlarge)


Covered call writing ETFs need to generate the extra revenue primarily from the call writing. As we have discovered through seeing long term declines in NAV at most of these funds, it isn't easy. LXF, HEX, HEF and ZWU have all failed so far and suffered falling multi-year NAV. Only ZWB has managed to hold its NAV at least level.

But that ignores another key issue - ZWB is falling well short in total return performance. Compared to another ETF composed entirely of financial stocks, the iShares  S&P/TSX Capped Financials Index Fund (TSX: XFN) it has exhibited the flaw discussed by Rob Carrick in the Globe when the flurry of covered call ETFs were launched in 2011, namely that they are more or less fully exposed on the downside but only capture a portion of the upside. XFN's one year total return to the end of February is 18.5% vs only 12.7% for ZWB.

Two other funds - FIE and XTR - rely on a rising market to generate capital gains that are distributed unrealized to shareholders as ROC. This works in the long term and cash payouts are sustainable, as long as markets rise more than they fall. Some years the constant payouts the ETFs have set will exceed gains, or the market will go down, and the funds distribute what is hopefully temporarily bad ROC, to be caught up when the market goes back up. XTR was launched in 2005 and survived through the
financial crisis so maybe it is a viable strategy. Its five year total return of 17.0% to the end of February even handily beat the 13.7% of a common benchmark fund, the iShares S&P/TSX 60 Index Fund (XIU) . There is a tax advantage to receiving immediately non-taxed ROC (which is taxed later as capital gains when the investor sells the shares) so such a fund can make sense for taxable investors who want cash now.

Finally there are the funds holding dividend stocks like ZDV and XEI, which only distribute what they actually receive from the holdings, i.e. mostly dividend income. We had to cut the table off for lack of space but other dividend ETFs (reviewed recently here) like XDV, PDC, PDF are not far behind. Other funds with higher payouts that similarly only distribute what they receive like REITs and preferred share holding funds are also not far behind.

Bottom line - High payouts often come with the downside that more cash now means lower long term returns. Funds that distribute only what the under-lying portfolio generates naturally have a much better prospect of long term sustainability. As the old expression goes, it's not possible to make a silk purse out of a sow's ear.

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.
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Tuesday, 11 March 2014

How to Avoid the Misery of T1135 Foreign Holdings Disclosure

When we last wrote about the T1135 Foreign Income Verification Statement, the form required by the Canada Revenue Agency when certain specified foreign assets of a Canadian taxpayer exceed $100,000 in cost, things were complicated enough. Well, things have got worse. The CRA is now requiring a lot more detail on the foreign assets and the rules as to when exactly the detail is needed or not have become even trickier.

A selection of articles on the T1135 trauma

Investors may well cry out - help! how do I escape this? Below we offer some suggestions for equity ETFs that escape the CRA net yet still provide foreign holdings for a portfolio. But first we need to narrow the task.

Amidst all the complexity, a few things are clear: 
1) Most notably for the majority of taxpayer investors, is that holdings within registered plans like RRSPs and other forms of registered retirement plans - LIFs, RRIFs, LIRAs etc, TFSAs, and RESPs are exempt from the necessity to report on the T1135, no matter what their value. 

2) Apart from these exempt accounts, what matters is not the currency of the holding, nor whether the broker is Canadian or outside the country, nor the stock exchange where the investment is bought or sold. Canadian company bonds denominated in US dollars are still Canadian. Royal Bank stock traded on the NYSE is still Canadian. US company stock held in a taxable Canadian discount broker account is still foreign. 

What matters is the domicile of the security, where it is registered. A mutual fund or ETF registered in Canada that holds foreign bonds or equities is still Canadian. 

Equity ETFs that avoid the T1135 rigmarole
We've sifted through the various ETF providers, like iShares Canada, BMO Financial, Horizons and Vanguard Canada who create bonafide Canadian registered funds that cover the broad passive equity indices covering the USA, Developed countries and Emerging Market countries worldwide. There are certainly many other qualifying ETFs from other providers such as First Asset, RBC, Invesco Powershares - see them all listed here on TMX Money - but we focus on the mainstream basic non-currency hedged portfolio building block funds. 

In the comparison table below, the T1135-avoiding funds are in green text. The three funds we like best within each geographic category are highlighted in green background.
(click on image to enlarge)

Note that many of the Canadian substitutes for US-registered funds have higher MERs and as a consequence have a higher tracking error i.e. tend to under-perform their respective index by a greater amount. On the other hand Canadian registered funds offer some advantages that enhance net returns, such as:
  • automatic, free distribution reinvestment;
  • avoidance of the need to exchange foreign currency since the ETF trades in Canadian dollars and handles the exchange internally much more cheaply than an individual investor can achieve (though a couple of the ETFs, ZSP-U and HXS-U, trade in US dollars in Canada on the TSX, and would thus not confer that benefit)
We did a few calculations using our free ETF comparison tool and found that the combined effects of all factors often gave quite close to the same net return for the Canadian-based and the US-based funds.

Our three favorites are:
Though it has a higher total expense load due to the combination of the management fee and the swap fee, the deferral of any tax until the investor sells shares plus the transformation of what would be annual foreign income distributions into capital gains can be very attractive in a taxable account. A Horizons fact sheet shows the benefit through a simple example.

International Developed  / Europe Australasia Far East equities - BMO MSCI EAFE Index ETF (ZEA)
The fact that it has a) a competitive MER plus, b) recovery of international non-USA foreign withholding tax by directly holding the foreign equities that is lost when a Canadian ETF holds a US-based ETF inside, is what wins for this fund.

Emerging Market equities - BMO MSCI Emerging Markets Index ETF (ZEM)
The reasons are the same as for ZEA - competitive MER plus no loss of withholding tax.

It should be noted that this fix for needing to fill in the T1135, if a person now already has assets that breach the $100k floor for reporting, cannot work immediately for a 2013 tax return, or even for a 2014 return. It can only be effective starting in 2015, since the rule is that it is the cost at any time during the year that matters, not what may be there at the end of the year. 

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.
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Monday, 3 March 2014

Tax-efficient Fixed Income for Non-registered Taxable Accounts

Some investors, especially those in high income brackets or those who save a lot, may have run out of RRSP and TFSA room, yet still want or need (e.g. because of a target asset allocation) to hold interest-paying fixed income in a non-registered taxable account. What are the options for such investments and how do they compare? A prime consideration is naturally after-tax income - which gives the best return after-tax and how much difference do the options generate? How do the options compare regarding other factors such as credit risk and interest rate risk and ease of portfolio management?

A couple of new ETFs - BMO's discount bond fund and First Asset's strip bond fund
A brand new ETF entered the scene just a few weeks ago, the BMO Discount Bond Index ETF (TSX symbol: ZDB). It holds a basket of high quality investment grade bonds whose key differentiating characteristic is a discount price to par value. That means return is partly capital gains as the bonds return to par value at maturity. On the web page of ZDB, the fact that the weighted average (of the holdings) coupon rate currently at 2.34% is less than the weighted average yield to maturity of 2.5% tells us so. (Note: The latter number is not yet posted on the fund's webpage, though the ETF's fund profile contains the 2.5% figure. BMO says the number will be posted and updated daily after the fund makes its first distribution on March 6.)

Back in June 2013, First Asset launched the First Asset DEX 1-5 Year Laddered Government Strip Bond Index ETF (BXF). It holds a basket of coupons and residuals that pay no interest; they only pay their principal back at maturity. Taxes are levied annually on the annual yield of each coupon or residual as if it were interest. The way the implicit interest is calculated and tax reported on an accruing rising basis (see TaxTips.ca explanation and example here) there is some tax efficiency in that more of the interest is reported in later years. BXF is thus a bit more tax efficient than a GIC. But it does not defer tax or pay out part of its return as lower-taxed capital gains. BXF primarily avoids the big problem today, that the vast majority of bonds are premium bonds that pay out more in interest coupons than the yield.  Canadian Couch Potato recently posted a good explanation of the discount bond benefit for taxable accounts and a review of ZDB, with links back to a previous post on BXF.

Bad Effects of Premium Bonds and Good Effects of Discount Bonds in a Taxable Account
We've taken a mix of a high interst savings account, GICs with terms ranging from one to ten years, individual bonds, the two ETFs mentioned above and as a benchmark, the iShares DEX Universe Bond Index Fund (XBB). Our comparison table below shows the results, before tax, such as would be achieved holding such investments in a registered account, and after-tax in a taxable account.
(click on image to enlarge)


Discount bonds help mostly by avoiding the premium bond penalty
ZDB and the individual discount bonds save only a little on tax compared to what the investor would pay if all the return was taxed at the rate of ordinary interest income. The green highlighted cells show a benefit of 0.04% to 0.17% extra return - not much. In contrast the benchmark XBB, which contains a preponderance of premium bonds, suffers a bigger 0.24% return penalty and one highly premium bond, the Canada 1 June 2019 maturity paying a 3.75% coupon and only yielding 1.51%, suffers even more.

Things would change if interest rates rose appreciably
It doesn't look as though interest rates in Canada are poised to rise anytime soon (2015 at the earliest, per the Bank of Canada) but if they did rise by 2% tomorrow, the advantage would shift strongly to discount bonds, as the lower half of the table shows. The ETF holdings don't change, so the coupon rate would stay quite stable in the immediate term (as we discussed in our review of XBB in a climate of rising interest rates). But the 2% risein required yield would mean that many premium bonds' falling price would make them discount bonds. XBB itself would become a discount bond fund. ZDB would even beat out after tax a GIC whose rate had gone up 2% to 5.45%.

BXF would shed its discount bond advantage much more quickly than ZDB and XBB since it only has a five year ladder and replaces about one fifth of its holdings every year, while the other two ETFs hold a vast range of bond maturities and they replace a much smaller proportion of their holdings annually. The more strongly interest rates / required yields rise, the more discount bonds there will be around and the bigger the discount, giving ZDB an increasing attractiveness.

Benefits of discount bonds vary a lot by Province
The relatively low taxation of interest in Alberta and Nunavut means that residents of those Provinces will gain much less from discount bonds than the highly-taxed residents of Quebec and Nova Scotia.
(click on image to enlarge)


After-Tax Returns not very good - most options can't beat inflation
At any maturity, our summary table of all the results shows that the best quality credit risk fixed income options provide weak returns - in most cases not even beating the latest low inflation rate of 1.5%. Only a couple of GICs do so along with one Province of Ontario bond.
(click on image to enlarge)


The GIC beats them all after tax
From the 1-year GIC on up to the 10-year GIC paying 3.45% interest, each has an appreciably higher return after-tax than any other option with comparable maturity. That's considering pure return only but there might be other reasons an investor might need or want to pick a fund instead of using GICs in a ladder.

Other considerations - GIC vs a discount bond fund

  • Rebalancing a portfolio to maintain an asset allocation easier in a fund - ETFs can be bought or sold in quantities as small as single share units while GICs are all or none, and the higher GIC rates come with non-cashable conditions. It's not possible to predict when rebalancing will need to happen, so matching GIC maturities with planned rebalancing, such as a yearly schedule will work somewhat. But the last time fixed income and equities went out of whack in a major way was during the 2008-09 financial crisis and who saw that coming?
  • Reinvesting interest / distributions easier in a fund - BMO's funds all offer automatic dividend reinvestment (DRIP) whereby distributions are reinvested in the fund at no commission cost. iShares and First Asset also offer a DRIP program.
  • GICs have CDIC coverage limits - Rock solid AAA deposit guarantees only apply on GICs up to 5 years. After that the longer term versions rely on the credit quality of the issuer, generally one of the big banks. There is also a limit of $100,000 covered per financial institution. High net worth investors may need to spread investments amongst several institutions, an inconvenience.
  • Controlling maturity and duration to match spending easier in a ladder - For investors with a definite date and intended amount of spending, using individual GICs (or bonds) can enable control of the effect of interest rate changes. The duration of any fixed income investment is equal to, or less than, its term. Recalling (explained in this post) that duration means the time at which the investor obtains the promised initial return no matter what happens to interest rates, a ladder of GICs can be adapted to planned spending. Meanwhile ZDB's duration of 6.7 years means an investor must stay invested at least that length of time to be sure of gaining the 2.5% yield to maturity. XBB's duration is about the same at 6.8 years. On the other hand, an investor in the savings phase of life with many years to planned spending may find the never-reducing multi-year duration of fixed income ETFs to be quite acceptable.
  • Diversification not really an issue - With such high credit ratings, holding a lot of different issuers, such as Provinces plus the federal government, doesn't reduce risk appreciably, it probably makes it worse. From a portfolio correlation perspective as well, GICs will be about as uncorrelated with equities as it gets. Holding an ETF with lots of bonds that have the same uncorrelation with equities but are highly correlated with each other won't help the portfolio.
Bottom Line - Discount bonds help boost after-tax returns in taxable accounts though GICs produce higher returns at the moment. In addition, the discount bond benefit is not very pronounced right now but the more interest rates rise, the greater will be the effect, especially in higher tax Provinces. ZDB will provide stronger benefits to taxable investors than BXF.

PS Thanks to reader sleepydoc for suggesting the topic.
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.
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Friday, 21 February 2014

Convertible Debentures: the Certs mint of investments

Many years ago a famous TV commercial for Certs featured a debate as to whether it is a candy mint or a breath mint.
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The answer was that it is both at the same time - "two, two, two mints in one". 

Step forward the investing equivalent, the convertible debenture, a hybrid security that has features of both debt and equity. It is a debenture debt which promises to make fixed regular payments and has a defined maturity date. But it also is convertible into equity of the company under certain conditions. When it works well, it provides the steady income of debt repayment with the potential for capital appreciation if the common stock rises in the market.

Our simple description above inadequately describes the many details and variations possible with convertible debentures. To ease into the subject, we suggest reading:
1) A Primer on Convertible Debentures - by Hank Cunningham, author of the book In Your Best Interest: The Ultimate Guide to the Canadian Bond Market; includes a brief intro to assessing convertibles
2) Convertible Debentures for Income & Growth - on the Income Research website, which charges a subscription for access to its ratings and ratio calculations for the various issues on the market  
3) Convertible Debenture Overview - by ScotiaMcLeod
4) Convertible Bonds: Combining the Advantages of Stocks and Bonds in One ETF - by Barrry Gordon of ETF provider XTF in CanadianETFWatch.com

List of Canadian Convertible Debentures
The Financial Post publishes a freely available list under Market Data. The screenshot below shows part of the list of almost 190 issues on the market.
(click image to enlarge)

The detailed conditions for each issue may be found on the company website, though the authoritative comprehensive source is the relevant Prospectus that issuers must file on SEDAR.com. Click on Search Database then Public Company Documents, then enter the Company name in the search box and Prospectus in the drop down box.

USA Convertibles
An easy way to get a list of convertibles of US companies is to download the holdings of an ETF focussed on that segment, such as the SPDR Barclays Convertible Securities ETF (NYSE symbol: CWB), which holds 100 of the largest issues.

Canadian ETFs, Closed End Funds and Mutual Funds
A few examples of debenture price action
1) Far out of the money, a "busted convertible" - Debenture price behaves according to bond value
Advantage Energy's conversion price is far below the current stock so the convertible AAV.DB.H hardly budges , there's no reaction to stock price movements and its value to an investor is the yield to maturity of 4.30% as the TMX Money chart below shows.
(click image to enlarge)

2) At the money, where stock and conversion price are quite close - Algoma Central's common stock price is slightly above the conversion price. In the last few months especially as ALC has risen, the price of its debenture ALC.DB has moved a lot more in sync with ALC. 

3) Deep in the money, where the stock price is far above the conversion price - Just a few days ago Cargojet (CJT) announced a huge contract and the stock price skyrocketed. So did the debenture's price, as seen below, to the point that the yield to maturity on the debt is a big negative 8.09%. That doesn't matter since debenture holders are now making a large capital gain based on the stock price. From now on till conversion into equity, CJT.DB.A will bounce up and down in tandem with the stock price.

Bad things can happen
If a company begins to get into financial difficulty, the stock price will go down, not increase, eliminating any possibility of capital appreciation. If the difficulties get too bad, the risk of default may impair the value of the debenture. As the primers above point out, an investor needs to assess credit risk among other things. And as the type of companies that issue debentures are usually smaller and not rated by the credit rating agencies such as DBRS, the self-directed investor must do more work him/herself. The provisions of each issue can vary considerably so it's a very good idea to check the Prospectus on SEDAR.

Nevertheless, convertible debentures can offer a solid way to invest in a security that offers the dual properties of equities and fixed income. The analogy with CERTS isn't perfect however, since you cannot be sure in advance whether it will be a candy mint, a breath mint, a bit of both, or even at times a possible sour taste.

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.
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Tuesday, 18 February 2014

Canadian Equity Market Darlings and Dogs: February 2014 Update

February 14th being Valentines Day, it's a good time time for our semi-annual look at the Canadian equities market to see which sectors and companies the market loves (the Darlings) or shuns (the Dogs). To do that we don't count flowers, champagne or chocolates, we compare the relative weightings of sectors and stocks in two ETFs:
  • the iShares S&P/TSX 60 Index Fund (TSX symbol: XIU), which selects its holdings and weights based on market capitalization and thus tracks market sentiment, against 
  • the iShares Canadian Fundamental Index Fund (CRQ), which chooses holdings based on past hard accounting results likes sales, dividends, cash flow and book equity value
We will also examine interesting changes in the Darlings and Dogs from previous comparisons in August 2013, February 2013, August 2012, January 2012, June 2011 and the original post in April 2010.

The Numbers
The table below shows the companies and the sectors colour-coded - Darlings in Green and the Dogs in Red. The table also shows the change in internal weighting over the past six months for each ETF, which tells us stocks and sectors that have been moving up or down, either in terms of price (XIU) or fundamentals (CRQ). The bigger shifts are highlighted in Bold.
(click on table image to enlarge)


As a cross-check to be sure the sector differences are not due to the fact that CRQ has 28 more holdings than XIU's 60 (which might tend to result in XIU being more concentrated and have higher individual percentages than CRQ) we've re-calculated weights for CRQ using only its top 60 holdings like XIU. This adjustment for the most part makes little difference to the results but it does matter a lot for the Consumer Discretionary, Information Technology and Utilities sectors and two banks - TD and Scotiabank.

Financials - Continuing the trend we noted last August, the convergence of the market view and the fundamental view is almost complete on an individual stock basis. Today there are no real Darlings amongst Financials, and there are only two Dogs - Manulife (MFC) and Sun Life (SLF).  That CRQ continues to have a much heavier weighting in our table in the Financials seems to be a quirk of XIU's construction.  Several Financial companies that are in CRQ such as Great West Life, Power Financial, Fairfax Financial Holdings (see the list of the main stocks not held by the other fund at the bottom of the table) don't even figure in the XIU portfolio even though those companies are firmly within the top 60 largest market cap stocks on the TSX.

Energy - The situation is much like August. There has been no further convergence of market view with fundamentals. CRQ still has more weight in Energy than XIU, thus keeping the sector as a Dog. However, one big company - Enbridge (ENB) - is still a market Darling. Encana (ECA) meanwhile remains as the perpetual and the most extreme Dog, with the largest difference in weighting between XIU, where it is in 21st place at 1.28% and CRQ, where it is 7th at 3.67% adjusted weighting.

Materials - Not much has changed in this sector either. Perpetual Darlings Potash Corp (POT) and Goldcorp Inc (G) remain so with stock prices at levels significantly higher than accounting fundamentals justify. Apart from those two stocks, the difference in weight between XIU and CRQ is due to the fact that XIU includes several miners excluded from CRQ, and whose cap weight is not in the top 60 anyway.

Telecommunications - As the expression goes, plus ça change, plus c'est la même chose - the two Darlings BCE Inc (BCE) and Telus (T) continue to be the object of market desire, being vastly overweight in XIU compared to CRQ.

Industrials - Canadian Pacific Railway (CP) continues its resurgence as a Darling, which along with perpetual Darling - Canadian National Railway (CNR) - makes the whole sector so.

Consumer Discretionary - This sector has fallen out favour and is now a mild Dog. Despite having two extra sector companies in XIU that add 1.18% in weight, the sector has less weight than it does in CRQ. Magna International (MG) is the largest example of the unloved in this sector.

Consumer Staples - It's steady-as-she-goes in this neutral sector. Individual companies themselves remain in balance too.

Health Care - The market loves both companies in this sector - Valeant Pharmaceuticals (VRX) and Catamaran Corp (CCT). By fundamentals, Catamaran is too small even to be included in CRQ yet it is the 32nd largest holding in XIU.

Utilities - Though there is one extra utility in CRQ, it puts a lot more weight in this sector. The market thinks the sector and individual companies are Dogs.

Information Technology - Blackberry (BB) continues its fall. As the fundamentals are catching up with the market view, it is less of a Dog.

The Darling and Dog sectors and stocks since 2010
Most sectors and companies are still in the same position of being either Darlings - Materials (Potash Corp and Goldcorp), Healthcare (Valeant) and Telecommunications (BCE and Telus) - or Dogs - Financials (Manulife and Sun Life) and Encana. Utilities and Consumer Discretionary are back to being Dogs. The brief moment last August when Darling sectors outnumbered Dogs has ended and there are now five Dog sectors and only four Darling sectors.
(click on image to enlarge)


How do the Darlings and Dogs stocks' numbers look?
As before, we checked the stocks in a Globe&Mail WatchList to see recent stock and company financial performance. This time we have a bit of a surprise. The table screenshot below shows surprisingly that Dogs Manulife and and Sun Life both have performed well! Manulife in particular looks interesting. It has just reported good earnings, continuing its recovering financial performance. Yet it's Price/Earnings is reasonably low at 14. As we said last August, perhaps there is more value yet to be recognized.
(click on table image to enlarge)


Valeant is the other end of the spectrum. To use our Valentine's Day theme, it is like an exciting affair, losing money but on an aggressive acquisition strategy that seems to enthral. Will it turn out to be long term love or just a disappointing affair?

XIU and CRQ, or other broad market funds can also be used directly as diversified investments for those investors who do not feel confident, or who don't have the time, to investigate individual stocks. The differences in weightings and holdings are only a couple of aspects in comparing the two ETFs. See our previous posts reviewing Canadian equity ETFs here, here and here.

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.
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Friday, 7 February 2014

Dividend Stock Olympics - The 15 Canadian Medalists

Inspired by the upcoming start of the 22nd Olympic Winter Games in Sochi, we decided to look at what's inside the Canadian equity dividend ETFs that we reviewed last week to pick out the athletes (companies) who qualify for gold, silver and bronze medals. Our selection method is similar to many Olympic sports like figure skating and freestyle skiing - the judges decide, in this case the managers of the various ETFs. Who scores the most points, i.e. which stocks show up in the holdings of the most ETFs? These stocks can be good candidates for investors who want to directly build a portfolio of solid dividend payers.

The 15 Medalists are (please stand for the national anthem) ...
Gold
It's not who you might think, like the Royal Bank, Canada's largest company by market capitalization, or any of the other banks, though there are a bunch in the medals. The one and only gold medal, since it is the only stock that appears in every single dividend ETF, goes to IGM Financial Inc. (TSX symbol: IGM) manager and distributor of financial products, mainly mutual funds under banners such as Investors Group, Mackenzie and AGF.

Silver
There are nine stocks in this group (it must be other countries who won the gold) as all but one of the ETFs, or seven out of eight, hold them:
  • Corus Entertainment (CJR.B)
  • Shaw Communications (SJR.B)
  • Bank of Montreal (BMO)
  • Bank of Nova Scotia (BNS)
  • CIBC (CM)
  • Great-West Lifeco (GWO)
  • Power Financial Corp. (PWF)
  • Rogers Communications (RCI.B)
  • TELUS Corp. (T)
Bronze
The competition is fierce and there are only five stocks that appear in six out of eight of the ETFs:
  • Canadian Oil Sands (COS)
  • Enbridge Income Fund Holdings (ERF)
  • Royal Bank of Canada (RY)
  • BCE Inc. (BCE)
  • Emera Inc. (EMA)
Our comparison table below shows which stocks appear in which ETFs. It confirms that most of the ETFs are quite alike for a good chunk of their holdings, the exception being iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (CDZ) whose selection criteria based strictly on increasing dividend payers has excluded most of the big banks since the 2008 financial crisis.


To get an idea of what might make these stocks so attractive, we created a watchlist in Globe Investor's old WatchList tool, entered the stock symbols and manipulated the columns with the result in the screenshot below. All the stocks have healthy five-year returns and a higher than average (the TSX Composite is about 2.7% at the moment) dividend yields that look quite sustainable given payout ratios. Only two stocks - COS and GWO - are very volatile compared to the market, i.e. sport a beta much over the market average of 1.0.


We note in passing that we investors should always be aware that data errors can creep into any source - Bank of Nova Scotia does not have negative cash flow!! If some number looks odd, it is well worth digging into. We also found a bunch of companies that had actually increased their dividends over the past five years, unlike what the Globe WatchList says. In this and the honourable mention list below, this includes ticker symbols RCI.B, CPG, MIC, MTL and RUS. Raw basic data generally is ok, it is derived values like ratios and growth rates where things get messed up. Globe and other resources like online brokers rely on outside data gathering companies who have a difficult job to compile the huge amounts of data investors want so errors do occur regularly.

Close but no medal
There is also a group of strong competitors, the chasing pack one might say, who appear in at least half the ETFs. The list of twenty-five stocks looks as follows:

We finally see stocks in sectors not represented at all amongst the medal winners, such as real estate, materials and industrials.The ETF CDZ widens its difference with the other ETFs, with even less of its holdings over-lapping.

The data for these stocks looks generally positive too, though returns haven't been as uniformly good, there are more volatile stocks and some have very high Price to Earnings ratios.

When it comes to stocks held by a minority of the ETFs, there is much less agreement. The ETFs spread over 122 stocks for their remaining holdings. CDZ is very much the most unique - it has no less than 29 stocks, 45% of its total number, that no other ETF holds. The next closest, PDC, has only 11% of its stocks held by no other ETF. The most conforming is ZDV, which holds not a single stock that no other ETF holds.

Bottom line:
The above stocks are a pretty good starting list for assembling a dividend portfolio. But it's good to keep in mind what can happen in the Olympics, especially when judges are involved - the winner isn't necessarily the best, only the one they liked the best. There may be one-performance wonders too. Be your own judge, as we are sure everyone likes to do anyway when watching the excitement of Olympic competition.

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.
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