Contributing editor Tom Slee joins us this week. He's been combing through the battered preferred share market looking for bargains and he likes what he's seeing. Tom managed pension money in the insurance industry for many years and is an expert in taxation. Here is his report.
Tom Slee writes:
The best investment advice you can get right now is "Tune out the media!" Switch off that drumbeat of despair. What a dirge. According to most commentators, the end is near. Even during the brief market rallies they bombard us with bad news and dire warnings. Talk about doom and gloom!
Take The Wall Street Journal, for example. It blazoned Warren Buffett's off-hand comment that "the economy has fallen off a cliff". In fact, he was somewhat optimistic in that interview, going on to say that most banks are healthy and will earn their way out of trouble. Mr. Buffett also pointed out that Wal-Mart and similar companies will actually benefit from the recession. What happened to even-handed reporting?
This relentless pessimism is taking its toll. Last week, one of my business associates, a seasoned investor, told me that he was liquidating his still substantial portfolios and getting out of the markets. He was determined to hoard his remaining capital. I was stunned. It was the first real case of personal investment capitulation that I have encountered. We discussed the situation but he was determined to play for safety. The never-ending stream of horror stories on TV and the Net had convinced him that investment values were spiraling down out of control.
I mention this because the client in question is a hard-nosed successful lawyer, now retired, who makes pragmatic decisions. If he is alarmed then it's likely many other investors may also be close to throwing in the towel.
That would be a mistake. Things are bad but not desperate. Although I do agree that the markets have deteriorated so much during the last few months that it's no longer sufficient to remain hunkered down until the storm passes. There are some fundamental economic and social changes taking place. The markets, when they recover, are going to be different. We have to be ready.
First, though, it's worthwhile stepping back and taking a cold, hard look at the situation. As I say, ignore the horror stories and try to get a grip on what is really happening. For a start, it now seems certain that the Canadian GDP will shrink in 2009. The most recent projections, after factoring in the global downturn and banking disasters, indicate a drop of about 2.4%. The Royal Bank thinks it will be 1.4%. To put that in perspective, during the 1981-1982 recession, a slump we can hardly remember, GDP fell 6.7% over a period of 18 months. More recently, GDP contracted 3.2% in 1990-1991. In other words, the current downturn is deep but not nearly as devastating as it seems.
Moreover, there is good reason to expect some recovery in 2010. The respected Economist magazine thinks that the Canadian economy will grow by 1% next year while the TD Bank is looking for growth of 1.3%.
When it comes to corporate profits, always of far more interest to investors, the numbers are all over the place mainly because of our broad exposure to international energy and commodity prices. Scotiabank believes Canadian earnings will plunge about 15% this year and show a modest 7% growth in 2010. TD expects a drop of 29% in 2009, followed by a 12% bounce next year. Other economists think that U.S. corporate profits will drop by 18% and then grow about 5% next year. Of course, these are forecasts based on rapidly changing statistics. The recession may be far longer and deeper than anticipated. My point, though, is that we are dealing with serious but not life-threatening numbers. This is not 'Apocalypse Now', something I tried to convey to my discouraged client.
That having been said, what do we do? Well, I think we should prepare for the worst and assume that the economists will have to mark down the forecasts. There are bound to be some more unpleasant surprises and the recovery may not get underway until 2011. We also have to allow for the fact that the landscape has changed. Investors have been hurt. It's going to take some time before people are as buoyant as they were in early 2007.
Therefore it's a good idea to start gradually switching from positions in emerging markets and small caps into dividend-paying blue chips that are likely to perform better during the early part of the cycle. The realignment will also build downside protection in your portfolio and generate more income while we wait for the recovery. Note that this is not a change in IWB policy, just a remainder that fine tuning is always a good idea.
As part of the program, more defensively-minded subscribers should also give some thought to shifting funds from equities into fixed-income securities. Short to mid-term Canada issues are the obvious choice but shell-shocked investors are still jammed up in the government sector and the yields are risible. For example, as I write the Canada 5.25% issue maturing June 1, 2013 is priced at $114 to yield 1.7%. However, mid-term top-quality corporate issues still offer safety and a decent return. The TD Bank 5.69% Notes due June 3, 2018 trade at around $102 to yield 5.1%. Loblaw's 7.1% issue due June 1, 2016 is priced at $104.35 to yield 6.34% and offers even better value.
These quotes are just to provide you with some guidance as to rates. They are not recommendations. Each bond issue comes with its own terms and conditions that may affect the market price. If you are seriously shopping for a mid-term corporate bond, my suggestion is the Manulife 4.67% issue due March 28, 2013 which is currently on our Buy list. These bonds are depressed because of Manulife's current problems and as I write they are priced at $94.63 to yield 6.2%. I think the company's problems are due primarily to the new mark-to-market accounting rules, in other words they are bookkeeping entries. The bonds are safe.
Take a look as well at blue-chip preferreds. For my money they are a much better bet than corporate bonds right now. Preferred shares have been badly battered by a combination of events. In September, then Treasury Secretary Henry Paulson seized Fannie Mac and Freddie Mac by issuing and buying up to US$200 billion of senior preferred shares in the institutions, essentially wiping out existing preferred shareholders. The preferred markets on both sides of the border nosedived. They have never recovered. Investors, associating these issues with common equities, have steered clear of the sector as the stock markets collapsed. To make matters worse, Canadian financial institutions have been flooding the preferred market with new issues in order to bolster their capital ratios. It all spells lower prices and resulting higher yields. It also spells opportunity.
In the first place, and contrary to conventional wisdom, I think that there is little to choose between corporate bonds and preferred shares when it comes to safety and reliability. True, bonds are higher in the pecking order in the event of liquidation but that is a technicality. The reality is that banks have priority and an iron hand during a bankruptcy. As a result, there is usually very little left for anybody else. Of course, bond interest is guaranteed and the company undertakes to repay the principal on a given date. On the other hand, preferred dividends are also almost guaranteed. A company will move heaven and earth before skipping a distribution. Any omission would destroy the corporate credit rating. Institutions would dump its bonds. As to a maturity date, preferred shares, unlike bonds, are listed on the exchanges and you can always get a proper quote and dispose of them at any time.
My point is that bonds and preferreds are comparable. You could even argue that preferred shares offer a couple of advantages. The dividends are paid quarterly and are nearly always eligible for the dividend tax credit. Bond interest is paid twice a year and is fully taxed in your hands if the bonds are in a non-registered account.
The big edge that preferreds have right now, however, is their price. Take the three issues on our Buy list. The Enbridge Series A (TSX: ENB.PR.A) is priced at $23 and yields 5.98%, equal to about 8.4% from a bond in an unregistered account after adjustment for the tax credit. Power Financial's Series D (TSX: PWF.PR.E) is trading at $18.38 and yielding 7.48%, equal to about 10.6% in a fully-taxed account. For those able and willing to assume some risk, the Bombardier Series 4 (TSX: BBD.PR.C) is yielding 8.9% or approximately 12.5% after the tax credit adjustment.
Updates on each of these issues follow. Keep in mind that preferred share and corporate bond values depend in the final analysis on the underlying earnings.
Tom Slee writes:
The best investment advice you can get right now is "Tune out the media!" Switch off that drumbeat of despair. What a dirge. According to most commentators, the end is near. Even during the brief market rallies they bombard us with bad news and dire warnings. Talk about doom and gloom!
Take The Wall Street Journal, for example. It blazoned Warren Buffett's off-hand comment that "the economy has fallen off a cliff". In fact, he was somewhat optimistic in that interview, going on to say that most banks are healthy and will earn their way out of trouble. Mr. Buffett also pointed out that Wal-Mart and similar companies will actually benefit from the recession. What happened to even-handed reporting?
This relentless pessimism is taking its toll. Last week, one of my business associates, a seasoned investor, told me that he was liquidating his still substantial portfolios and getting out of the markets. He was determined to hoard his remaining capital. I was stunned. It was the first real case of personal investment capitulation that I have encountered. We discussed the situation but he was determined to play for safety. The never-ending stream of horror stories on TV and the Net had convinced him that investment values were spiraling down out of control.
I mention this because the client in question is a hard-nosed successful lawyer, now retired, who makes pragmatic decisions. If he is alarmed then it's likely many other investors may also be close to throwing in the towel.
That would be a mistake. Things are bad but not desperate. Although I do agree that the markets have deteriorated so much during the last few months that it's no longer sufficient to remain hunkered down until the storm passes. There are some fundamental economic and social changes taking place. The markets, when they recover, are going to be different. We have to be ready.
First, though, it's worthwhile stepping back and taking a cold, hard look at the situation. As I say, ignore the horror stories and try to get a grip on what is really happening. For a start, it now seems certain that the Canadian GDP will shrink in 2009. The most recent projections, after factoring in the global downturn and banking disasters, indicate a drop of about 2.4%. The Royal Bank thinks it will be 1.4%. To put that in perspective, during the 1981-1982 recession, a slump we can hardly remember, GDP fell 6.7% over a period of 18 months. More recently, GDP contracted 3.2% in 1990-1991. In other words, the current downturn is deep but not nearly as devastating as it seems.
Moreover, there is good reason to expect some recovery in 2010. The respected Economist magazine thinks that the Canadian economy will grow by 1% next year while the TD Bank is looking for growth of 1.3%.
When it comes to corporate profits, always of far more interest to investors, the numbers are all over the place mainly because of our broad exposure to international energy and commodity prices. Scotiabank believes Canadian earnings will plunge about 15% this year and show a modest 7% growth in 2010. TD expects a drop of 29% in 2009, followed by a 12% bounce next year. Other economists think that U.S. corporate profits will drop by 18% and then grow about 5% next year. Of course, these are forecasts based on rapidly changing statistics. The recession may be far longer and deeper than anticipated. My point, though, is that we are dealing with serious but not life-threatening numbers. This is not 'Apocalypse Now', something I tried to convey to my discouraged client.
That having been said, what do we do? Well, I think we should prepare for the worst and assume that the economists will have to mark down the forecasts. There are bound to be some more unpleasant surprises and the recovery may not get underway until 2011. We also have to allow for the fact that the landscape has changed. Investors have been hurt. It's going to take some time before people are as buoyant as they were in early 2007.
Therefore it's a good idea to start gradually switching from positions in emerging markets and small caps into dividend-paying blue chips that are likely to perform better during the early part of the cycle. The realignment will also build downside protection in your portfolio and generate more income while we wait for the recovery. Note that this is not a change in IWB policy, just a remainder that fine tuning is always a good idea.
As part of the program, more defensively-minded subscribers should also give some thought to shifting funds from equities into fixed-income securities. Short to mid-term Canada issues are the obvious choice but shell-shocked investors are still jammed up in the government sector and the yields are risible. For example, as I write the Canada 5.25% issue maturing June 1, 2013 is priced at $114 to yield 1.7%. However, mid-term top-quality corporate issues still offer safety and a decent return. The TD Bank 5.69% Notes due June 3, 2018 trade at around $102 to yield 5.1%. Loblaw's 7.1% issue due June 1, 2016 is priced at $104.35 to yield 6.34% and offers even better value.
These quotes are just to provide you with some guidance as to rates. They are not recommendations. Each bond issue comes with its own terms and conditions that may affect the market price. If you are seriously shopping for a mid-term corporate bond, my suggestion is the Manulife 4.67% issue due March 28, 2013 which is currently on our Buy list. These bonds are depressed because of Manulife's current problems and as I write they are priced at $94.63 to yield 6.2%. I think the company's problems are due primarily to the new mark-to-market accounting rules, in other words they are bookkeeping entries. The bonds are safe.
Take a look as well at blue-chip preferreds. For my money they are a much better bet than corporate bonds right now. Preferred shares have been badly battered by a combination of events. In September, then Treasury Secretary Henry Paulson seized Fannie Mac and Freddie Mac by issuing and buying up to US$200 billion of senior preferred shares in the institutions, essentially wiping out existing preferred shareholders. The preferred markets on both sides of the border nosedived. They have never recovered. Investors, associating these issues with common equities, have steered clear of the sector as the stock markets collapsed. To make matters worse, Canadian financial institutions have been flooding the preferred market with new issues in order to bolster their capital ratios. It all spells lower prices and resulting higher yields. It also spells opportunity.
In the first place, and contrary to conventional wisdom, I think that there is little to choose between corporate bonds and preferred shares when it comes to safety and reliability. True, bonds are higher in the pecking order in the event of liquidation but that is a technicality. The reality is that banks have priority and an iron hand during a bankruptcy. As a result, there is usually very little left for anybody else. Of course, bond interest is guaranteed and the company undertakes to repay the principal on a given date. On the other hand, preferred dividends are also almost guaranteed. A company will move heaven and earth before skipping a distribution. Any omission would destroy the corporate credit rating. Institutions would dump its bonds. As to a maturity date, preferred shares, unlike bonds, are listed on the exchanges and you can always get a proper quote and dispose of them at any time.
My point is that bonds and preferreds are comparable. You could even argue that preferred shares offer a couple of advantages. The dividends are paid quarterly and are nearly always eligible for the dividend tax credit. Bond interest is paid twice a year and is fully taxed in your hands if the bonds are in a non-registered account.
The big edge that preferreds have right now, however, is their price. Take the three issues on our Buy list. The Enbridge Series A (TSX: ENB.PR.A) is priced at $23 and yields 5.98%, equal to about 8.4% from a bond in an unregistered account after adjustment for the tax credit. Power Financial's Series D (TSX: PWF.PR.E) is trading at $18.38 and yielding 7.48%, equal to about 10.6% in a fully-taxed account. For those able and willing to assume some risk, the Bombardier Series 4 (TSX: BBD.PR.C) is yielding 8.9% or approximately 12.5% after the tax credit adjustment.
Updates on each of these issues follow. Keep in mind that preferred share and corporate bond values depend in the final analysis on the underlying earnings.
