BONDS: Investing for the long, long, long term

BONDS
Investing for the long, long, long term
MARTIN MITTELSTAEDT

From Tuesday's Globe and Mail
Published Monday, Nov. 08, 2010 5:16PM EST
Last updated Wednesday, Nov. 24, 2010 11:37AM EST

Goldman Sachs (GS-N167.60----%) just issued a 50-year bond. The Government of Mexico, U.S. railway giant Norfolk Southern Corp. (NSC-N62.44----%), and Dutch banking conglomerate Rabobank Group did one better: They all recently issued bonds with the stupendous term of 100 years.

The clamour from investors for these ultralong bonds is raising eyebrows in the capital market. The Goldman issue is slated to return investors their money way off in 2060, while 100-year bonds won’t pay back their principal until a century from now.

Bonds are basically just a way to lend money, but until recently it was unusual for any investor to be so trusting as to lend money for up to a century. During such an extended period, bond issuers can run into revolutions, depressions, bankruptcies and all manner of other reasons for non-repayment. Up until now, normal terms for long bonds were considered to be 10 and 20 years.

Despite the risks, yield-hungry investors are snapping up these superlong-term securities. While 10-year government bonds are yielding around 2.75 per cent, Goldman and the other issuers of long, long bonds are offering the tempting inducement of rates around 6 per cent.

The high yields explain the popularity of the offerings, but the bonds’ terms are so extreme that many market pros believe they are a signal that the long-running bull market in fixed-income securities has reached the limits of rationality. Investors fixated on finding a good yield are ignoring the dangers that go along with investing in bonds that won’t mature for a couple of generations or more.

Going 'Very, Very Wrong'

“Some of these deals are going to go very, very wrong,” frets Ric Palombi, a fixed-income portfolio manager at McLean & Partners Wealth Management, who oversees approximately $1-billion in assets.

Mr. Palombi isn’t buying the bonds for his clients, and is surprised they’ve become a hit. “I never thought they would be so prevalent.”

The Goldman issue is a poster child for the continuing frenzy in the capital market for long-dated instruments. The Wall Street bank originally hoped investors might have the appetite for $250-million (U.S.) worth of the securities, according to market chatter at the time of the issue last month.

But Goldman sold more than five times as much – $1.3-billion. Ordinary ma and pa investors were the target buyers, signified by Goldman chopping the bonds into minuscule $25 amounts. This is an unusual size. Bonds typically trade in minimum multiples of $1,000.

How They Work

It’s not clear how many of the small investors who bought Goldman’s bonds realize the fine points of the deal. According to the prospectus, Goldman has reserved for itself the right to redeem the bonds at their face value of $25 on five days’ written notice any time after Nov. 1, 2015.

If interest rates stay low, Goldman, which didn’t respond to a request for comment, will likely call the bonds and pay off investors. Those seemingly high yields will then vanish.

Meanwhile, if market interest rates return to more normal levels because the economy recovers or inflation resumes, it’s likely that the cost of borrowing for extremely long terms could rise well above the 6.125 per cent that Goldman is paying. In that case, Goldman won’t redeem them, and buyers will be stuck with losses because bond prices move inversely to interest rates.

It’s telling that, while Goldman has the right to redeem, buyers weren’t given the same right to force Goldman to buy back the securities if interest rates surge.

While investors in any long-term bond face the risk of the issuer defaulting, any strong uptrend in interest rates also poses a problem.

Bond prices are in the midst of the longest bull market on record, having rallied in the United States for the better part of 29 years. Back in 1981, when the bull run began, 10-year U.S. Treasuries were yielding about 15 per cent and were shunned as “certificates of confiscation” by investors. Now the yield is a tad under 3 per cent and investors are snapping up bonds.

What Goes Up...

Nothing goes up forever, some analysts caution.

“Within a couple of years, the bond market probably is going to be entering some kind of [long-term] bear market,” says Frank Hracs, who compiles the Canadian Mutual Fund Analyst, a publication that tracks fund inflows and has found the hottest area is currently in bonds.

Mr. Hracs worries that the “long-term outlook for bond capital gains is negative.”

The losses owing to any rise in rates could be devastating. If rates revisit their 1981 levels, the 50-year and 100-year bonds will collapse in value by about 60 per cent.

MORE RELATED TO THIS STORY

• Bubble alert: Where risk lurks in 2011
• Fixed-income veteran upbeat on U.S. fortunes
• How the bond rally bears the markings of a bubblePublish Post

Some passive advice from Benjamin Graham

Benjamin Graham, Mr. Buffett's mentor, is required reading for anyone who is serious about active investing. He died in 1976 and, during that year, he said the following:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was first published; but the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

Advisers: Who should you trust with your money?

ADVANCED INVESTING

Advisers: Who should you trust with your money?

Investor Education Fund

Published Tuesday, Mar. 31, 2009 9:49AM EDT

Last updated Tuesday, Mar. 23, 2010 11:31AM EDT

"There are no requirements for managing billions of dollars, but before somebody can trim your sideburns, he or she has to pass some sort of test. Given the record of the average fund manager over the last decade, maybe it should be the other way around." – Peter Lynch, Beating the Street

MORE FROM THIS TOPIC

• How your adviser is paid
• Poor adviser practices that can be harmful to your financial health
• Advice on assessing your adviser: A consumer checklist

How do you find a good adviser?

Although Peter Lynch’s comment is focused on fund management, the minimum requirements to become a licensed adviser are easier to get than in some other professions that have much less of an impact on your long-term well-being. In Canada, there are many people that are eager to manage your money but it can be difficult to find somebody that will do it well.

The best ones don’t necessarily drive posh cars, wear expensive suits, or have big corner offices. But they do share these three characteristics:

• superior service
• consistent returns and with reasonable risk
• a focus on your success first, before their own.

Unfortunately, too often you can only learn how an adviser measures up after you have entrusted your money to them. There is no common rating system that lets you sort out the good advisers from everybody else. But there are three things you can -- and should – check before you choose an adviser:

• Qualifications
• Experience
• Performance

After all, it’s your money that’s on the line -- not theirs. Make sure you’re putting it into the right hands.

1. Assessing an adviser’s qualifications

The fact that an adviser has the basic qualifications to work in the industry will not tell you very much about their skill level. To register as an adviser, he or she only has to meet the bare minimum qualifications to operate in the industry. So when you look at qualifications, look beyond the minimum.

What to look for:

• Check that the adviser and their firm are registered and in good standing with industry regulators. Check now.
• Find out if the adviser has any additional qualifications, such as chartered financial analyst or chartered accountant. It takes considerable work and expertise to achieve these and other professional accreditations. This means they can offer added insight and a richer perspective to you.
• See if the adviser has made a commitment to ongoing professional development and skills development. A person who is committed to continuous learning will more likely serve you as a valued adviser, and not just sell you products.

What questions should I ask before I choose an adviser?

2. Assessing an adviser’s experience

Merely having experience in the industry does not make someone an excellent adviser. Experience may help an adviser understand and assess financial markets, but it does not guarantee the right focus on client returns. Nor does it necessarily teach advisers to focus on the long-term value of protecting their clients from the intense industry pressure to generate commissions.

The best advisers have learned, through experience, to make sure that costs are reasonable; that returns are fair; that recommended strategies and products are among the best available; and that clients feel comfortable and confident through good markets and bad.

What to look for:

Find out how long the adviser has been working in the industry and how long they have been working for this specific company. Learn about their philosophy and their company's investing philosophy.

Check that the adviser works with a broad range of products, not just one or two specialties, so they can help you find the right investments for your stage in life.

Interview a number of advisers before you choose one and ask them about their experience and investment philosophy. For instance, ask them what lessons they have learned over the years, and what they do differently today than they did five years ago (or when they started in the business). You can have a very interesting conversation with someone if you ask them about mistakes they have made and what they learned from them!

3. Assessing an adviser’s performance

It takes a long-term view and considerable emotional maturity for an adviser to balance making money for themselves with fair returns for their clients. As we will explore in future articles, most advisers are paid by commission -- and that commission often brings an incentive to make certain decisions.

The best advisers focus on returns rather than commissions. They understand the effects of fees and capital losses on client returns. They also know how to prepare clients for the volatility of financial markets.

Unfortunately, this type of adviser is less common than you think and takes a concerted effort to find. Make sure you:

• Take the time to interview advisers to uncover their philosophy, their commitment to their profession, and the type of service that they will provide to you.
• Make it clear to your adviser that you will monitor the relationship based on the relative performance of your portfolio against a reasonable benchmark.

Investors need to demand low-cost and market-comparable performance from their investments. This happens far too rarely today – and investors need to change this.

What to look for:

• Make sure the adviser has good references and a demonstrated track record.
• Check how the adviser has performed in both up and down markets.
• Ask how long they have worked with most of their clients. Talk to at least three clients the adviser has worked with for five years or more.
• Talk about how the adviser is paid. The best situation is where you and the adviser profit or lose together. Next best is an advisor who is paid to provide advice, but has no financial stake in the decisions you make. Neither of these are very common as the commissioned sales model is standard in the industry.

The problem with commission selling

One of the biggest enemies of long-term returns are fees. Commission selling can become problematic when it comes to fees because some of the most popular products are the most expensive for consumer because they are so lucrative for the salesperson.

For example, Canadian equity mutual funds with fees of approximately 2.5% are some of the most popular investment products in Canada. If these funds regularly provided returns that outpaced the Canadian equity market over the long-run, this strategy would make sense. However, this usually isn’t the case- only a handful of funds have outpaced the market consistently over the long run, despite the 1000s of funds (literally!) that are available.

Despite the fact that most mutual funds trail the markets in terms of return, you don’t often see full service brokers that recommend investing in an exchange-traded fund when a similar mutual fund is available. The adviser needs to get paid, and the mutual funds offer higher fees- even if it means generally below market returns for you. This is one example of how commissions create incentives for advisers to do questionable things for your portfolio.

Remember: advisers are important- but they can’t do it all

Investors need to be aware of what their advisers can and can’t do. An adviser can be great at some things, such as:

• adding value with access to good research
• offering tools and advice regarding asset allocation
• helping you maintain investing discipline and focus.

In the early stages of a relationship they can help you through all of the documentation to define your investment type and asset allocation. They can help you access proven, low-cost managed and index products and help you screen out much of the bad product.

However, investors need to watch their portfolio closely and put pressure on their advisers to keep fees in line with overall returns. After all, just because somebody is qualified to do a job, or has experience, does not mean that they will behave in a way that maximizes your investment return. So learn as much as you can about an adviser before you put your hard-earned money in their hands.

Building an income: Ming's story

CASE STUDIES
Building an income: Ming's story
Investor Education Fund
Published Tuesday, Mar. 31, 2009 10:20AM EDT
Last updated Tuesday, Mar. 23, 2010 11:35AM EDT

With $20,000 extra to invest, Ming likes the idea of investing for income. But he doesn’t want to invest too conservatively. He hopes to retire within the next 10 years, and he wants to grow his savings without taking on too much risk.

Ming decides what to do: Ming sat down with his adviser, and together they created a portfolio that would balance income and growth. Here what they did with the money:

· Put $5,000 in a five-year, non-cashable Guaranteed Investment Certificate (GIC): Ming will get about $175 a year in interest from this investment, guaranteed.

· Put $5,000 in a 10-year government bond: He will get about $200 in interest each year from this investment, guaranteed.

· Put $10,000 in preferred shares: Ming hopes to get about $400 each year in dividends, paid as $100 once every three months. Here, there’s no guarantee. He plans to hold the stock for now so he won’t have to pay tax on any capital gains.

Result: Ming will get some of this extra income yearly, and some more often. Some of the money is guaranteed, and some of it is not. By putting about half of his money in non-guaranteed income investments (the preferred shares), he hopes to balance income with growth.

There are also certain tax benefits. The preferred shares pay dividends, which are taxed at a much lower rate than interest. That means Ming will be able to keep more of the income he makes from investing. He plans to reinvest this income so he can keep growing his savings until he retires.

How do I make or lose money on stocks?

How do I make money from stocks?

You make money in two ways:

1. You sell when the price is higher than you paid.
   
   Example: Let’s say you buy a stock when the price is $10 a share. A year later the price goes up to $11 and you sell. You will make $1 on each share you own, minus fees or taxes.
   
   
   
2. You get dividends.
   
   Example:
   
   
   Let’s say you bought 100 common shares of a company at the start of the year. At the end of the year, you get a dividend of 25 cents a share. That means you made $25 in dividends that year (100 shares x 25 cents = $25). Some years, you may get a higher dividend. Some years, you may get a lower dividend, or no dividend at all.

Tip: Before you buy a stock, ask these questions: Is this stock’s price likely to rise over time? Does the company pay dividends often?

How do I lose money from stocks?

1. You sell when the price is lower than you paid.
   
   
   Example: Let’s say you buy a stock when the price is $10 a share. A year later, the price has dropped to $9. If you choose to sell then, you will lose $1 on each share you own. You’ll also have to pay fees for selling the stock.
   
   
   Tip: You don’t really lose money on your stock investment until you sell. You may decide to hold on to the stock and hope that its price will rise. There’s no way to tell for sure if the price will rise again or how soon. It could even fall lower. As an investor, you have to decide when you should sell. Or, get help from a registered adviser.
   
   
2. The company whose stock you own goes out of business.
   
   
   This doesn’t happen often. But a company can go bankrupt if it can’t afford to pay its bills. Its stock will drop a lot in value and may even become worthless.

Remember: There is no sure thing in the stock market

For better results, learn as much as you can before you invest your hard-earned cash. You may also want to get professional advice.