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Why We Own Stocks

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September 22, 2014 , , , ,

With the equity market sell-off at the beginning of August, investors have been reminded once again that there is risk to investing in the stock market, but before hitting the panic button, it is worthwhile to review why we suggest allocating at least part of your portfolio to equities and why stocks are still likely to offer the best total return over the medium to long-term.

While some people have called the stock market a casino or worse, investors need to be reminded that each share of stock represents a fractional ownership of a business. When you buy shares of Apple, Pfizer, BCE or TD Bank, you are becoming a fractional owner in those enterprises. The value of that business is based on the future earnings and cash flow that those companies generate. Buying shares of good companies at a reasonable price has been and likely will continue to be one of the best methods of building long-term wealth.

The main reason that people have bought equities is to generate higher returns in their portfolio. This is called the Equity Risk Premium (ERP). The ERP represents the additional return that investors have earned owning equities over other asset classes. Historically, equities have provided a 4% higher return than bonds1 per year. If the investment is in a taxable account, that premium is even higher as equities generate capital gains and dividends, both of which are taxed at much lower rates than bonds (interest income). Please note though that the 4% premium is an average, meaning in some years the benefit will be much greater than 4% and in other years equities may earn a lower return than bonds or a negative return.

Inflation Hedge: While bonds offer security – a fixed coupon payment from issue to maturity date as long is there isn’t a default, investors bear inflation risk. This is the risk that if inflation increases, the fixed coupon payments from the bonds will have a lesser value, because these cash flows will not be able to buy the same amount of goods and services, i.e. have less purchasing power.

1727060_sSince equities are public companies, typically when inflation rises, these companies find ways to continue generating higher profits by raising prices and /or cutting costs. E.g. if inflation rises, Walmart, McDonald’s, Royal Bank and TransCanada Pipelines typically find ways to continue increasing profits (and potentially dividend payments to shareholders) through changes in pricing or cost cutting measures, thereby protecting the investor’s purchasing power.

Participate in Economic Growth: While economies do experience contractions from time to time, typically Gross Domestic Product (GDP) increases over time. As the economy expands, so should earnings of quality public companies (equities). Historically, these companies will generate more in sales and be able to increase prices during periods of economic expansion, and be able to reduce costs during periods of economic weakness, which should lead to higher earnings per share (EPS). Higher EPS typically leads to higher stock prices and often to higher dividend payments over time. In short time periods, particularly recessions, equity prices may decline even if earnings rise, but on a long-term basis, equities have been one of the best ways for investors to benefit from economic growth.

Low Interest Rates: While interest rates are expected to rise in the first half of 2015, we expect the increases to be small initially and the pace of the increases to be slow. Low interest rates benefit equities in a few ways: 1) relative attractiveness – institutions and individuals need to put their investment dollars somewhere. When interest rates are low, the relative attractiveness of stocks, particularly those that pay a dividend, is greater, i.e. when your choices are investing in a GIC paying less than 2%, and a government bond paying less than 2.5%, investing in stock that pays a 3% dividend and offers the potential for capital gains is quite appealing. 2) enhanced earnings – with low interest rates, companies need to devote less of their revenues to debt payments, which enhances profit margins and overall earnings. Higher earnings typically leads to higher stock prices. 3) Share buyback – many companies are using their savings on debt costs to buy back their shares on the market. If the number of shares outstanding decreases and earnings remains relatively the same, earnings per share (EPS) improves as well. From Q2 2013 to Q2 2014, U.S. companies bought back approximately 3.3% of their shares outstanding2; these share repurchases increased earnings per share.

While we do not expect equity returns similar to 2013 or 2014 in the year ahead, we still expect equities to outperform other asset classes in 2015. Because of their many benefits, equities should remain a key part of each investor’s portfolio over the long-run.

The overall percentage of equities to own in an investment portfolio, and the type of equities to hold (large capitalization vs. small capitalization, developed market vs. emerging market) are best determined by meeting with a trusted investment counsellor and /or financial planner. A trusted planner reviews their clients’ income and cash flow needs as well as taxes to determine the clients’ needed rate of return. An investment counsellor analyzes investments to determine the best return prospects relative to each investor’s willingness and ability to take risk in his investment / retirement portfolios.

 

[1] http://www.seeitmarket.com/quantifying-equity-risk-premium-13202/. Quantifying Equity Risk Premium, Allan Millar, January 30, 2013. Based on S&P500 Index return vs. U.S. Government and Corporate Bond Indices. Data set from Ibbotson 1926-2010.

[2] http://www.factset.com/websitefiles/PDFs/buyback/buyback_6.18.14. FactSet Quarterly Buyback S&P500, June 18, 2014.

 

Lorne Zeiler
Written By:
Lorne Zeiler, MBA, CFA
VP, Portfolio Manager and Wealth Advisor
Lorne can be reached by email at lorne@tridelta.ca or by phone at
416-733-3292 x225
Cameron Winser
Written By:
Cameron Winser, CFA
VP, Equities
Cameron can be reached by email at cameron@tridelta.ca or by phone at
416-733-3292 x228

Risk Management Series – Bonds, Part 2

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October 25, 2013 , , , , ,

Why Do Bonds Trade at a Premium?

Bond pricing is a function of a number of moving parts: namely, coupon rate, market interest rates, credit quality, and term to maturity.  As a result, bonds often trade at a premium or discount to their maturity value (usually $100); this can cause confusion and frustration for investors.

We outline some of the key elements of bond pricing and its relationship to current market interest rates so that you can better understand how bonds are priced.  As mentioned in Part 1 “Risk Management Series – Bonds”  in between the date when a bond is issued until its maturity date, its market price (the price at which the bond trades in the market) will fluctuate.

When a bond is issued, its coupon rate (interest rate paid on the bond) is reflective of the current market interest rate environment for bonds of similar quality and that have a similar term to maturity.  E.g. if Royal Bank of Canada issues a 5 year bond maturing on September 30, 2018 and the market interest rate for similar bonds is 3.0%, then the coupon rate on the Royal Bank of Canada will be approximately 3.0%.

iStock_000000674097XSmallIf interest rates decline after a bond was issued, then any bond paying a higher coupon rate than the market interest rate should have a premium value.  For example if market interest rates for 5 year bonds decline from 4.0% to 3.0%, then a bond that pays a coupon rate of 4.0% is now worth more, because the investor is receiving 1.0% more in payments per year than the market rate.  Consequently, the bond with the 4.0% coupon should trade at a premium (trade at a higher price than it was issued at) to balance out the higher fixed interest payments.

In order to determine how much of a premium (or discount) each bond should trade at, fixed income (bond) portfolio managers compare bonds of similar quality with similar maturity dates using a calculation called Yield to Maturity (YTM).  This calculation determines the total return an investor can earn on a bond purchase based on: 1) the bond’s current market price, 2) its coupon rate, 3) maturity date and 4) maturity value (usually $100.00).

For example, let’s say Royal Bank issued a 10 year bond in September 2008 paying a 5% coupon rate with a maturity date of September 30, 2018 (Bond A).  Royal Bank also issues a 5 year bond on September 2013 that matures on September 30, 2018 with a coupon of 3.0% (Bond B).  So even though the bonds were issued on different dates, they currently have the same maturity date and as such are quite comparable.

Bond A should trade at a premium because from now until maturity, Bond A investors will receive 2% more each year in interest income than Bond B investors ($10 in total benefit over 5 years).  Based on the yield to maturity calculation, Bond A would have to trade at the premium price of $109.22 to offer a total return of 3% per year for the investor (the higher price offsets the higher interest payments).  Consequently, bond investors today may notice that many of the bonds in their portfolios were bought for prices well above their $100 face values, but that these bonds likely have higher coupon rates.  Bond A’s premium will decline each year (also known as price decay) as it approaches maturity, because it is one less year that you are collecting the higher coupon rate.      To get a fuller picture, investors need to look at both purchase price AND the coupon rate offered by each bond.

The objective of the portfolio manager is to provide the greatest total return to the investor, which includes both the loss (or gain) on the value of the bond PLUS the interest payments received.  If the portfolio manager feels they can earn a higher total return by buying a bond with a higher coupon rate, but it trades at a premium, they will do so.  In the example above, if he can buy Bond A for $108, they could earn 3.25% per year for their clients vs. just 3.0% by buying Bond B.  A large part of a fixed income portfolio manager’s job is to perform these types of comparisons to try to attain higher total returns for clients.

Accumulated Interest

Another reason that a bond may trade at a premium is to reflect accrued interest.  Most bonds only pay interest two times a year (semi-annual payments).  For example if the bond was issued in December, it will make coupon payments in June and December; if the bond was issued in March, it will make coupon payments in March and September.  But, if you buy the bond on the market in between those coupon payment dates, you essentially are getting additional payments.

For example, if a bond makes payments in June and December and you buy the bond in May, you will have held the bond for one month, but you will have received 6 months’ worth of interest.  Bond prices reflect this benefit, typically by adding the accumulated amount of interest owing to the purchase price of the bond.  For example, if a $100 bond is paying a 6% interest rate (paying $3 twice a year) and the investor buys that bond at the end of April, there is $2 of interest already built up, so the bond should trade for $102.

Bond pricing, performance and payments are often quite complex and difficult to understand, because unlike equities where investors generally look primarily at its current market price vs. purchase price to see if they made money on their investment, bonds require analyzing both the purchase price AND coupon payments received.  As described above, there are many times when a bond investment may appear to have a negative return from a price perspective, but has often provided a positive return once you have included the coupon payments.

Illustration of Pricing of Bonds A and B from the article

Bond A Pays a 5.0% coupon.  Bond B pays a 3.0% coupon.  Both bonds mature in 5 years, September 30, 2018.

Annual Coupon Payments Bond A Bond B
September 30, 2014 $5.00 $3.00
September 30, 2015 $5.00 $3.00
September 30, 2016 $5.00 $3.00
September 30, 2017 $5.00 $3.00
September 30, 2018 $5.00 $3.00
Total Payments: $25.00 $15.00
Difference: +$10 Bond A trades at premium due to higher coupon payments
Lorne Zeiler
Written By:
Lorne Zeiler, MBA, CFA
VP, Wealth Advisor
Lorne can be reached by email at lorne@tridelta.ca or by phone at
416-733-3292 x225

Risk Management Series – Bonds

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October 3, 2013 , , , , ,

Are Bonds Still Safe?

Investors have historically been told that bonds, while generally offering lower returns, are the safe portion of their investment portfolio. Over the past few months through mid-September, nearly all bond (fixed income) investors have lost money and in many cases these losses have been greater than 5%. So this raises the following questions: are bonds still a ‘safe’ investment? Why had they gone down recently? What do we expect in the future? Should they still be included in your portfolio?

What are Bonds?

Bonds are a contractual obligation by the borrower (issuer). The borrower (usually a government, government agency or corporation) agrees to pay a specified amount of interest (coupon) for a fixed period of time and to return the principal amount to the investor on the maturity date.

Why are bonds considered Safe Investments?

If you buy a bond issued by a financially strong company or government and you hold that bond until maturity, you nearly always make a positive return, as the bond issuer repays your principal (amount that you originally invested) AND interest. Bonds are considered safer than stocks, because all that has to happen for an investor to earn this positive return is that the company or government not go bankrupt, i.e. if the company is still an operating business on maturity date, the bondholders have to be paid their principal investment and their interest earned. Even in the event of a bankruptcy, bond holders often get paid in part or in full since bond investors have priority to the company’s assets.

Stocks by contrast are not a contractual obligation. Investors buy stock (equity) based on that company’s future earnings, i.e. the company’s ability to increase profits. If the company is unable to increase its net income (profits) over time, its stock is likely to decline in value.

Why have bonds gone down recently?

In between the date that a bond is issued and the date it matures, its price fluctuates based on a number of factors, including: interest rates, general economy, market sentiment and volatility, default risk, liquidity and for foreign bonds, changes in currency values. As a result, investors can earn more or less than the coupon amount (or even experience a loss) during periods of time in between the purchase date and maturity date of the bond. While the two main factors that typically affect bond prices are credit and interest rates (more will be discussed on these factors at the end of the article), the recent price decline has largely been a result of central bank policy, particularly quantitative easing.

iStock_000010237072XSmallQuantitative Easing – The Main Reason for the Recent Drop

Quantitative easing was initiated by the U.S. central bank, the Federal Reserve, as well as the European and Japanese central banks, amongst others, to help stimulate their economies following the Financial Crisis in 2008. These central banks, in addition to setting overnight interest rates near 0%, bought longer maturity government and mortgage bonds to increase money supply and flatten the yield curve. For example, since September 2012, the Federal Reserve has been purchasing $85 billion of longer-date U.S. treasury bonds and mortgage backed securities each month, which equates to over $1 trillion per year .

The aim of quantitative easing is to suppress interest rates for longer-dated bonds. This forces investors into riskier investments to earn a reasonable return, such as corporate bonds, equities and real estate and encourages businesses to invest and consumers to spend because of the low cost of credit. As a result, interest rates on 10 year bonds have been held near historic lows since 2009 and were between only 1.5% to 2.0% for most of the past year.

This changed in April 2013 when the Federal Reserve Chairman, Ben Bernanke and other officers started talking about tapering (reducing) these bond purchases, i.e. reducing and then eliminating the quantitative easing program. Investors feared that without the central bank as buyers that longer-term interest rates might go way up in the future, so many began to sell (i.e. if supply of bonds remains the same and demand (central bank purchases) goes down, yields go up). The interest rate on the 10 year US Treasury for example has gone from 1.62% in early May to 2.94% as of Friday, September 6th. Holders of those 10 year bonds have lost more than 10% during that three-month period as bond prices have gone down, i.e. for current 10 year bonds to move from a yield of 1.6% to 2.94%, their price must drop by over 10%. TriDelta’s own fixed income portfolios experienced losses during that period of 3.4% for Core and 4.7% for Pension.

What Do We Expect for the Future?

While we at TriDelta believe that interest rates are likely to go up in the future, we expect that this process will take much longer than most people believe, perhaps a number of years. We also believe that bond yields have gone up too high and too fast over the past six months. The performance of bonds over the past two weeks seems to back-up this view. The Federal Reserve decided on September 18th to not taper its quantitative easing program. Since then bond prices have gone up over 3% as reflected by the US 10 year bond. We at TriDelta believe there could be a further opportunity over the next number of months to generate more gains as bond yields continue to decline. We also believe that corporate and high yield bonds provide attractive returns as many of these companies are in a strong financial position with low overall level of debt and offer a premium yield to government bonds.

Why Include Bonds in an Investment Portfolio

In addition to being considered the safe part of the portfolio, bonds provide a reliable income stream and have a low and negative correlation with equity markets.* This means that if the equity market declines, bonds are likely to increase in value, providing downside protection for a portfolio. Investors often sell their equity holdings due to fear, these same investors buy bonds during these periods for security. By including bonds in a portfolio, they reduce overall volatility and often enhance overall returns. Lowering volatility also has the benefit of helping investors stick to their financial plan. While we do expect equity markets to be higher in the long-term, there will be periods where we could experience drops, bonds should help protect client portfolio values, enabling them to attain their investment goals.

*http://blogs.wsj.com/moneybeat/2013/09/06/rising-bond-yields-cast-shadow-over-equities/

 

Key Risks to Consider for Bonds in Normal Markets

Credit Risk reflects the potential that a bond could go into default, i.e. declare bankruptcy or issuer is unable to refinance. In that case, the investor would not be paid their interest and could lose some or all of their principal investment. This potential risk is reflected in the interest rate paid by the issuer. The higher the perceived credit risk (risk of a default), the higher the coupon (interest) rate. Typically, when the economy declines (recession) or growth slows, investors become more worried about the risk of default. Consequently, investors during those instances demand a higher interest rate (coupon) from corporate and high yield bond issuers.

Bond managers can often enhance returns by buying more corporate or high yield bonds when the economy is improving or growing and credit spreads decline and can protect returns by owning more government bonds when the economy is declining. Typically, government bonds pay the lowest interest rate as they are considered the lowest risk, then high quality corporations pay slightly higher, but still low rates, such as BCE, TransCanada Pipeline and the Royal Bank of Canada, with riskier companies, such as Barrick Gold Corpoation, paying a higher coupon.

Maturity Date / Interest Rate Risk – Bonds with longer maturity dates tend to pay a higher interest rate than those with shorter maturity dates. This is because there is more certainty in what will happen in the short-term, so investors are willing to accept a lower interest rate. In the longer-term, there is more uncertainty (will rates go up? will there be higher inflation?), so investors expect to be compensated with a higher interest rate to take on the risk of this greater uncertainty. When short-term interest rates increase as a result, yields on bonds go up (bond prices go down), but not in a uniform way. Yields on bonds with a longer maturity dates could go up more, meaning that their prices drop more. For example, if interest rates go up 1%, a 5 year bond will likely see its price drop by 4-5%, while a 10 year bond will likely see its price drop by 8-10%. The inverse happens when short-term interest rates go down – longer dated bonds prices go up more.

Portfolio Managers who can anticipate when short-term interest rates may rise or drop and adjust the maturity dates of their bond holdings to reflect their views, can enhance returns for their clients.

 

Lorne can be reached at lorne@tridelta.ca or by phone at (416) 733-3292 x 225.

Edward can be reached at edward@tridelta.ca or by phone at (416) 733-3292 x 229.

Risk

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September 6, 2013 , , , , , ,

This is article one in a five part series on the topic of RISK. The articles will be as follows:

  1. Determining the Appropriate Risk Level for a Portfolio
  2. Why have bonds (a ‘safer’ asset) gone down in price recently?
  3. Why equities are ‘riskier’, but offer higher potential long-term returns
  4. Understanding volatility (risk vs. reward)
  5. Countering Investor Behavioural Biases (How to protect yourself and your portfolio from making emotional mistakes)

 

Part one – Determining the Appropriate Risk Level for a Portfolio

10922382_s2One of the greatest disconnects between investment professionals and their clients is understanding and interpreting risk.  For most investors, risk is essentially the potential that an investment could lose money (typically over a short time period).  In particular, an investment is considered more risky if there is a greater probability of a loss (negative return) and if that loss could be substantial.   But, focusing solely on this singular view could lead an investor to miss out on opportunities for higher return and the danger of not having sufficient funds for retirement.

For example, an investor owning a portfolio of only GICs believes she is taking on zero risk as the GICs, if held to maturity, should give her back her principal investment plus a small amount of interest.  But, if the investor needs to earn a return of 5% per annum to fund her retirement, a portfolio of GICs paying 2% actually has a great deal of risk – the hazard of not meeting her investment goal.  In this scenario, the investor is at a 100% risk of not meeting her retirement goals, requiring her to work longer or reduce expenses substantially during retirement.

Determining Risk Level in Your Investment Portfolio

Instead of focusing solely on short-term losses or gains, you should consider the following three questions to determine your appropriate investment portfolio for retirement planning:

  1. What is the minimum return / level of income needed in retirement?
  2. What is the desired return / level of income wanted during retirement?
  3. How much loss (as a percentage or total dollar amount) can I withstand (typically over a short time frame)?

The first question addresses the minimum amount of return that needs to be earned to ensure that you can enjoy a basic lifestyle in retirement.  This is the amount that must be safeguarded against.  But the key issue here is time horizon.  If you are in or near retirement, AND you cannot risk losing a significant amount in a short time period, the portfolio would generally be income oriented and conservative.  By contrast, if you are in your early 40s, you can invest more in assets that have a higher return potential, but still have more chance of a potential loss in the short-term, such as equities (stocks).  The younger investor can accept a decline because she has a longer period to recoup those losses when market returns are stronger.  This occurs over nearly all medium-term and longer term periods (5 yrs +), where riskier assets like equities have provided higher total returns.

The second question addresses the kind of lifestyle you would like to have in retirement and then placing a dollar value on it in terms of after-tax income to ensure there is enough money for travel, entertaining and gifts.  A higher return is often necessary to attain the desired lifestyle.  Risk is managed by rebalancing, so taking profits (selling) when equities have gone up and over time increasing the allocation to more income oriented and conservative investments.   Often the cash (or GIC) position is increased for near retirees to ensure the minimum level of income is attained, but then taking a bit more aggressive approach with the remaining investments to attain the desired lifestyle.

The third question requires complete honesty, because investors are most tempted to stray from their investment plan when markets decline.  These are often the times when it is most important to stay on the plan, particularly as equities (stocks) tend to go up after markets have gone down.  If you cannot accept any loss greater than 5% without wanting to sell everything and becoming extremely nervous and agitated, then you should have a zero percent allocation to equities and a low allocation to longer maturity and/or higher yielding bonds .  It is better, if you are highly risk averse to forego potential  gains in order to save yourself from the pain of losses.  If you are working with a financial planner / investment advisor, he /she should set your equity or riskier asset weighting based on a typical bear market (20-25% decline) to an extreme bear market (50% decline).  E.g. if an investor is willing to accept a potential 15-20% decline in their investments than an equity (stock) allocation of approximately 50% would be appropriate (a 35% decline, which is the midpoint between the two decline scenarios of 20% and 50% multiplied by .5).

A TriDelta Financial planner can work with you to determine the proper investment allocation to meet your goals and to set a plan in place to meet those goals by working with you to answer the three questions listed above, but being forthright and honest about current net worth, income, attitude towards loss, retirement expectations and any unique circumstances (health concerns, an inheritance, selling or buying of a property, etc.) will make this process and your financial plan more successful.

Lorne can be reached at lorne@tridelta.ca and by phone at 416-733-3292 x225.

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