Debt & Frugality

As Didi says in the novel (Findependence Day), “There’s no point climbing the Tower of Wealth when you’re still mired in the basement of debt.” If you owe credit-card debt still charging an usurous 20% per annum, forget about building wealth: focus on eliminating that debt. And once done, focus on paying off your mortgage. As Theo says in the novel, “The foundation of financial independence is a paid-for house.”

A Q&A about Fixed Income investing with Franklin Templeton’s Jon Durst

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Earlier this year, the Hub ran a blog by Franklin Templeton Canada entitled A cure for the headaches of Fixed Income investing, written by Ahmed Farooq, Vice President of ETF Business Development for the company. Franklin Templeton is a sponsor of the Hub. Today’s blog is a question-and-answer session between Ahmed’s colleague, Jon Durst, Vice President, ETF Business Development, that picks up where we left off. 

Jon Chevreau, Q1: Do you believe active management makes more sense in the fixed-income space versus the equity space? Perhaps it makes sense in both?

Jon Durst, Franklin Templeton’s Vice President, ETF Business Development

Jon Durst: There are merits to active management in both equities and fixed income; however, I feel recently, it has been a heavy skew towards active fixed income in this current market environment, and for many reasons. Early in March 2020, we saw a 50bps cut in interest rates by the Fed in the US: it was the first unscheduled rate cut since 2008 and the biggest cut since the financial crisis.  There also appears to be a strong consensus on the street that rates will be “low for longer” going forward.  If you own a passive fixed income strategy, the goal is to minimize tracking error to the index and what it cannot do is to adjust or try to anticipate any type of market events, like interest rate changes or changing company fundamentals.

This can certainly be a worrisome event for most advisors if they buy their own bonds directly or passive fixed income products covering different sectors/regions, as they have to scramble and figure out if they should continue with the same fixed income allocations in their portfolio, as the onus of making any changes to their portfolio will be on them.

Active managers with years of experience can focus solely on their investment mandates and can adjust to different types of market events, such as shape of the pandemic recovery or the consequences of the Democrats winning the 2020 US elections.

Outsourcing in this market environment and buying active fixed income exposures that align with your client’s outcomes will hopefully provide a calming effect that is certainly needed.  Not to mention, active fixed income ETFs in particular are now often priced very similarly to passive indexed products, which is even more important in this low rate environment to help maximize clients cash flow.

Jon Chevreau, Q2: For income-oriented retirees, do you generally see more opportunity in corporate or government bonds?

Jon Durst: I do see more opportunity in corporates debt, as the yields are higher, they also tend to be less sensitive to interest rate movement, but the risk level and volatility do tend to slightly go up.

A passive aggregate bond strategy that encompasses both corporate and government debt in Canada yields around 2.55%, a pure passive Canadian government bond strategy at 2.11%, and a passive Canadian corporate strategy around 2.77%.  On the other hand, for example, an active Canadian corporate strategy FLCI – Franklin Liberty Canadian Investment Grade Corporate ETF, yields 3.12%. An active manager can select certain bonds over others, perhaps looking for higher coupons and/or YTMs, or overweighting certain sectors that will benefit from the pandemic trade or the Biden Presidency.

Jon Chevreau, CFO of Financial Independence Hub

Jon Chevreau, Q3:  How much exposure should Canadian investors have in US and international bonds and through what vehicle? On that note, what is your stance on currency hedging?

Jon Durst: We do need to think outside of Canada; even from a fixed income perspective, Canada’s total debt in comparison to the world is about 3-4%.  Also, there is no tax incentive to buying solely Canadian debt, unlike the Canadian Dividend Tax credit provided on distributions from Canadian equities.  There are many fixed income opportunities to take a look at – a solution based option via a Canadian Core Plus strategy is one – where you would still keep 70-75% in Canadian bonds and have an active manager select the 25-30% in the US and/or globally.  You could also consider a more broad-based global aggregate option, having the portfolio manager look for opportunities from a global stand-point, which offers the PM a lot of flexibility to diversify geographically and from a currency perspective.  Yields in different countries can vary significantly which can create a lot of opportunity for higher yields and capital appreciation, not to mention diversification benefits.

In terms of buying a pure-based exposure – in other words, buying direct US, EAFE or EM debt, either by purchasing individual bonds or a managed product — I find most advisors are still tippy toeing into pure US, EAFE or EM debt spaces: most still maintain a home country bias and the complexity of selection, weighting, and trading these exposures is difficult, to say the least. Those that see the value in investing outside of Canadian debt usually outsource this complexity by using active fixed income strategies that provide access to the US/Global exposure, in addition to Canadian bonds.

I am for 90-100% in currency hedging fixed income exposures.  With interest rates and yields being at historical lows, another level of worry should not be placed on how the global currencies are going to perform relative to the CAD$, especially in fixed income, which is supposedly the conservative component of a client’s portfolio.  In my opinion, currencies should be hedged out as much as possible in fixed income.

Jon Chevreau, Q4: Your blog back in February compared bond funds to GICs. Do you see a role for both and in what proportion?

Jon Durst: In this environment, it can get even trickier: do you really want to lock into GICs for a certain period of time at a certain rate? Or want to be nimble and have liquidity? It’s a question on how to balance stable income that is locked in (currently at historically low rates) and/or including a short term bond strategy that can yield a little more in this environment and provide liquidity in the event of a requirement. I am beginning to see a fair number of advisors who have started to allocate to short term bonds funds as client GICs mature. Usually cash, GICs and short-term bond funds make up about 5-10% of a clients portfolio, but GIC investors are being compensated very little, so short term bond funds are being used for those with a higher need for income, and cash now being used for those with a 100% capital preservation requirement (not taking inflation into the equation).  GICs appear to be losing some steam.

Continue Reading…

Owning today’s Long-Term bonds is crazy

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By Michael J. Wiener

Special to the Financial Independence Hub

Today’s long-term bonds pay such low interest rates that it makes no sense to own them.  There is virtually no upside, and rising interest rates loom on the downside.  Warren Buffett called this “return-free risk.”  He was right.  Here I explain the problem and address objections.

As I write this, 10-year Canadian government bonds pay 0.623% interest.  If you invest $10,000, you’ll get a total of only $623 in interest over the decade, and then you’ll get your $10,000 back.  This is crazy.  Even if inflation stays at just 2%, you’ll lose $1237 in purchasing power.

Even worse are 30-year Canadian government bonds that pay 1.224% as I write this [late in October 2020.]  Your $10,000 would get a total of $3672 in interest over 3 decades.  This is a pitiful amount of interest over a full generation.  At 2% inflation, you’ll lose $1738 in purchasing power.  Even a portfolio that only beats inflation by 2% per year would gain $8113 in purchasing power over 30 years.

All investments have risk, but there has to be some potential upside to justify the risk.  Where is the upside for long-term bonds?  The only upside comes if we have sustained deflation.  It’s crazy to risk so much just in case the prices of goods and services drop steadily for the next decade or three.

Some investors mistakenly think they can always sell bonds and collect accrued interest.  That’s not how it works.  With a 30-year bond, the government is promising to pay you the tiny interest payments and give you back your principal after 3 decades.  If you want out, you have to sell your bond to someone else who will accept these terms.  You don’t get accrued interest; you get whatever another investor is willing to pay.  Counting on selling a bond is hoping for a greater fool to bail you out.  If future investors demand higher interest rates on their bonds, your bond will sell at a significant capital loss.

If the interest rate on 30-year bonds goes up over time, that’s actually bad for current bond owners, because they have to live with their lower rate instead of receiving the new rate.  If 30-year bond interest rates go up by 1%, you immediately lose 30 years of 1% interest; you can’t just sell to avoid the loss because other investors wouldn’t happily take these losses for you.

Let’s go through some objections to this argument against owning today’s long-term bonds:

1.) Stocks are risky

It’s true that stocks are risky, but I’m not suggesting that investors replace long-term bonds with stocks.  Short-term bonds and high-interest saving accounts are safer alternatives.  A decision to avoid long-term bonds doesn’t have to include a change in your asset allocation between stocks and bonds.  For anyone willing to look beyond Canada’s big banks, it’s not hard to find high-interest savings accounts paying at least 1.5% and offering CDIC protection on deposits.  If long-term bond interest rates ever return to historical norms, it’s easy to move cash from a savings account back into bonds.  So, you don’t have to live with a measly 1.5% forever.

2.) Investors need to diversify

The benefit from diversifying comes from owning assets with similar expected returns that aren’t fully correlated.  However, the expected returns of today’s bonds are dismal.  We don’t really own bonds for diversification these days.  The real reason we own bonds is to blunt the risk of stocks.  It doesn’t make sense to try to reduce portfolio risk by buying risky long-term bonds.  Flushing away part of your portfolio with long-term bonds isn’t a reasonable form of diversification.  Short-term bonds and high-interest savings accounts do a fine job of reducing portfolio volatility without adding significant interest rate risk.

3.) Long-Term bonds have higher interest rates than short-term bonds

Historically, long-term bonds rates usually have been higher than short-term rates.  Today, however, high-interest savings accounts pay more interest than long-term government bonds.  But that’s not the only consideration.  Interest rates will change over the next 30 years.  If you own short-term bonds, your returns will change too.  However, if you buy 30-year bonds, your interest rate won’t change for three decades.  If interest rates rise, new short-term bond rates will be higher than your old 30-year rate.  Continue Reading…

How I used to sabotage my portfolio

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By Mark Seed, myownadvisor

Special to the Financial Independence Hub

Some recent reader questions prompted me to update this post – let’s go!

Dedicated readers of this site will know I spend a lot of time writing about what’s working in my financial plan and how incremental money management changes are moving us towards financial freedom every month.

Certainly if you look back at my decade in review you can see we’ve made some tremendous progress towards financial independence over time.

That doesn’t mean I didn’t sabotage my portfolio …

With all the success we’ve had to date, it wasn’t without missteps and mistakes. We’re not immune to bad decisions now and then.

In fact, we used to sabotage our portfolio and our personal finances. We really didn’t know what we didn’t know.

Financial disaster

Over the years we’ve learned some financial lessons and so today’s post updates those lessons so you don’t have to make the same mistakes I did. In fact, should you find yourself in one of these financial ruts below this post will go a step further and offer some tips on how to dig out of them.

I should know, I made these changes below!

Here is how I used to sabotage my portfolio – and what you can learn from it.

1.) Investing in high-priced mutual fund products

In my 20s, I invested in mutual funds that charged money management fees close to 2%. Back then I simply didn’t know how much those fund fees would eat into my investment returns. On top of that, I had no idea that most mutual fund managers had no long-term hope of beating their benchmark index, even after a few years let alone after many years.

This is because of this key reason: it is incredibly difficult to overcome the deficits incurred by some funds due to high money management fees charged.

High fund fees basically mean you’re already striving to play catch-up to market-like returns.

Needless to say, we don’t invest in any costly funds any longer. I ditched the mutual fund industry about a decade back now – a decision you can read about including the costly math behind it here.

This is not to say there are not a few mutual funds in Canada, and the companies that manage them, that continue to shine in terms of long-term performance – thanks to their lower-cost structure and diversified approach over their competitors. Lower-cost solutions such as Tangerine funds, Mawer funds and some TD Bank products (e-series funds) come to mind.

If you’re just starting out, you can read this post about some of those alternatives.

You can also now consider some simple all-in-one funds to help you with your investing solutions.

The bottom-line: since lower money management fees are a major predictor and input into future investing gains, it’s best to keep more of your hard-earned money working and less money going out to management fees that offer little to no long-term value.

Beyond my links above, do check out my ETFs page for some of the best, low-cost, diversified funds to own. I’ve also highlighted which ones I own and why!

2.) Lacking diversification – it’s a free lunch!

Did you see the current pandemic coming?

Can you predict gold prices later this year?

I thought so. Same here.

At the end of the day, I have no idea what the future holds. Don’t let any financial expert tell you they know either.

Nobody can predict the future with any accuracy what will happen next. This is why for long-term investing success we should strive for diversification, but it wasn’t always that way for me.

In those aforementioned 20s, the younger My Own Advisor Do-It-Yourself (DIY) investor threw tons of money into tech stocks in the late-1990s. The internet (for those millennials reading this post!) was actually a new thing then. Continue Reading…

BBC StoryWorks #3: The case for locking in to Fixed-rate Mortgages at today’s ultra-low interest rates

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The third article of six planned to appear on the BBC StoryWorks website in Canada has now been published. You can find it by clicking on the highlighted headline here: Embracing the Fixed Rate Mortgage.

As explained in the first instalment, the articles look at Covid-19 and the impact on the real estate and mortgage industry. The articles appear weekly and run into November.  The last three articles will look at the case for locking the investing experience following Covid, optimum strategies going forward and close with retirement strategies in the age of Covid.

In the second article of the series we made the case for why you might want to go with a variable rate mortgage and keep your interest costs as low as possible at today’s historically rock-bottom rates. In this article — written with my input and sponsored by TD Bank — we take the opposite view and present the argument why you might consider locking in to the safety and security of a 5-year fixed rate mortgage.

After all, there’s a lot more room for rates to rise than fall from here, and staying variable may be especially stressful for those with larger mortgages. True, you may be able to save a few basis points in interest charges by staying short but at what cost in anxiety and sleepless nights?

Variable mortgage rates remain a tad lower than fixed but is it worth taking a gamble with variable to get the absolute lowest rate or is it better to choose the safety and security of a fixed rate mortgage? Today’s record low 5-year fixed rates has made Lethbridge-based fee-only financial planner Robb Engen (and regular Hub contributor) rethink his past strategy of staying variable.  He points out any upside with variable rates is largely gone now as the prime rate is likely as low as it’s going to get.

Both variable and fixed rates may be under 2% these days

“Fixed and variable mortgage interest rates [for the same term] are pretty comparable these days,” says fee-only financial planner Jason Heath, managing director of Toronto-based Objective Financial Partners.
Continue Reading…

4 big Rip-offs to avoid

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I’ve made my share of bad financial decisions over the years, but nothing feels worse than when a salesperson convinces you to buy something that’s not in your best interest. These kinds of rip-offs usually occur when one party has more or better information than the other.

Think about the first time you bought a car or the first time you went to the bank to sign your mortgage documents. Who controlled the conversation? If you were like me, you probably deferred to the “expert” sitting across the desk and happily signed everything they put in front of you

Related: 10 Fees To Avoid Paying

What you might not have known at the time is that some of the extras, such as extended warranty coverage or balance protection insurance for your credit card, were completely optional and most likely a giant waste of money.

Here are four big financial rip-offs to avoid:

1.) Mortgage life insurance

If you own your home, chances are you were offered mortgage life insurance from your bank. This type of insurance is not a requirement to qualify for a mortgage, but it’s made to look that way by many lenders who suggest it at a time when you’re vulnerable and haven’t shopped around. You’ll even have to sign a waiver form to decline the coverage.

The reality is that it’s generally not a good idea to buy mortgage life insurance from your bank. It’s the one financial product that goes down in value as you continue to pay: also known as a declining benefit. Term life insurance is much cheaper and offers greater protection.

2.) Extended warranty coverage

It’s almost guaranteed that you’ll be asked to buy an extended warranty the next time you purchase an appliance or any high-end piece of electronics. The reason for the hard sell is that retailers have big profit margins on these contracts. Stores keep 50 per cent or more of what you pay for extended warranties or service plans, according to Consumer Reports research.

Consumer Reports recommends against buying extended warranty coverage. One reason is that most repairs may be covered by the manufacturer’s warranty, which should last at least 90 days or longer. Their research suggests that if a product doesn’t break while the manufacturer’s warranty is in effect, it probably won’t during the service-plan period.

Related: Gadget Insurance – Is It Worthwhile?

Many credit cards will double the manufacturer’s warranty when you use the card to make the purchase and register the product.

3.) Balance protection insurance

One common telemarketing pitch from banks and credit card lenders is for balance protection insurance.

For a cost of about 99 cents per $100 of the average daily balance (about 1 per cent per month) you can protect your credit rating against unexpected job loss or disability.

Customers might agree to add this protection to their credit card thinking that because they pay off the balance in full each month they’ll avoid the fee. Not so. The fee can based on the amount owing on your statement due date, or on your average daily balance, depending on the card issuer.

Not only that, the “protection” is riddled with exclusions, making it difficult to make a claim should you become ill or lose your job.

A CBC Marketplace investigation revealed how bank employees mislead and up-sell consumers on pricey credit card balance protection insurance. I’ve had personal experience with this, as CIBC added the insurance protection to my credit card account last year without my permission. More recently, my wife signed up for a card with TD and upon activation the customer service agent pushed balance protection coverage. When my wife declined, the agent persisted and asked, “why not?” Continue Reading…