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Praise for In Your Best Interest
“(In Your Best Interest) is full of excellent information and advice that’s presented in a smart and highly readable format. If you want to learn more about the fixed-income markets and how they really work, Hank’s book is a must read!”
— Debra A. Hewson, President and CEO, Odlum Brown Limited
“I’ve always been impressed by Hank’s knowledge of the bond market.”
— Mark Bunting, host of Market Call Tonight, BNN
“Wise, justifiably opinionated, and clearly written — accessible to the ordinary investor.”
— Thomas Kierans, Chair of the Social Sciences and Humanities Research Council and a Senior Fellow of Massey College at the University of Toronto
“Hank Cunningham is a widely acknowledged authority on Canadian fixed-income investing.”
— Robert C. Caldwell, Managing Director (BFS), Macquarie Private Wealth Inc.
“In my opinion, it is the essential guide for anyone interested in learning about our fixed income markets and in particular the Canadian bond market.”
— Bob Moore, investor
Author's Note
Author’s Note
This book contains numerous numbers, tables, charts, graphs, and calculations. While the author has made every effort to provide accurate information at the time of publishing, neither the publisher nor the author assumes any responsibility for errors or for changes that occur after publishing.
IN YOUR BEST INTEREST
THE ULTIMATE GUIDE TO THE CANADIAN BOND MARKET
Third Edition
W.H. “Hank” Cunningham
This edition is dedicated to my daughter Valerie
Acknowledgements
Besides reiterating my acknowledgements to Lyman MacInnis, his son Alan, and Stuart Henry in inspiring the first edition, I would like to extend my gratitude to several other people. First, I would like to thank Odlum Brown Limited for giving me the opportunity to work with them. I owe a special thanks to Debra Hewson, the CEO of Odlum Brown, for her support.
In addition, there are many individuals who have contributed to this edition either directly or indirectly. Among these are Jeremy Fleming, Robin Hanlon, Peter McRae, Murray Leith, Tom Kierans, Stephanie Riopelle, and Kevin Prins.
Through my website and from media appearances, I have had the pleasure of speaking with many individuals who have contributed solid suggestions for this edition. It is heartwarming to know that my book has struck a chord with people who are interested enough to offer me ideas to make it a better book. Thanks to all of you.
Finally, I wish to acknowledge the love and support that my daughter Valerie has provided me, always.
Introduction
Welcome to the third edition of In Your Best Interest. In this edition, I have added a lot of new content, including a chapter on Exchange Trade Funds (ETFs), a new section on forecasting interest rates, and beefed-up sections on preferred shares, convertible bonds, and real return bonds (RRBs). I have also included an update on Canada’s ABCP fiasco and what has happened in the income trust sector.
The core principles of this book remain unchanged; individual investors, through a laddered portfolio of individual interest-bearing bonds or zero coupon bonds, are able to preserve their principal while obtaining satisfactory returns. The events of the past three years certainly underscore the importance of maintaining well-balanced portfolios with the fixed-income portion designed to avoid the four biggest risks to fixed-income portfolios:
1 Maturity risk (also known as reinvestment risk)
2 Credit risk
3 Inflation
4 Currency
All of these factors can be mitigated using a laddered approach; I have long favoured ladders with maturities from one to ten years. This allows investors to capture the extra yield available in the six- to ten-year maturities, while at the same time the average term of the portfolio is only just over five years. Ten-year maturities allow for greater credit selection while a steady parade of maturities ensures that, should inflation become a problem, money will be available for reinvestment at higher yields.
Most Canadians will retire in Canada and will need Canadian dollar income. It is imprudent, in my view, to diversify a fixed-income portfolio out of the Canadian dollar, since, with today’s low nominal yields, a small adverse currency move can wipe out any extra yield. The explosion in ETFs has not swayed my view on owning individual bonds; there is such a bewildering array of choices that investors end up guessing again. I think that specialty ETFs such as high-yield or emerging-market bond funds might have a role to play, but for regular investing, I prefer individual bonds and GICs. While it is true that ETFs have lower fees than do mutual funds and are designed to merely track an index, they share the same major fault that mutual funds do: they never mature and you don’t know what their future value will be.
Credit Crunch
Lehman Brothers bankrupt, Bear Stearns sold for peanuts, Merrill Lynch absorbed by Bank of America! Who could have guessed that these icons would disappear and that hundreds of billions of dollars would be needed to prop up many other institutions, including the likes of General Motors? This was all triggered by the subprime fiasco and the accompanying collapse in the underlying derivatives. The housing market entered the biggest swoon since the Great Depression and it remains severely depressed today. In turn, this is having an adverse effect on the employment market, as many jobs go unfilled as the mobility of labour is severely hampered by the weakness in the housing market.
Nevertheless, a global economic recovery did get underway but has proven to be a halting, sub-normal one. To be sure, the emerging market countries of China, India, Singapore, Brazil, and others have displayed solid growth. However, we are experiencing a rolling sovereign debt crisis in Europe which, so far, has focused on Ireland, Greece, Portugal, Spain, and Italy. It shows no signs of ending.
It is a curiosity of this cycle, particularly in the United States, that both the corporate and the consumer sectors have conducted serious deleveraging while the U.S. government has had to undergo the indignity of a credit rating downgrade as the politicos in Washington seem unable to put together any meaningful fiscal package.
During this time, monetary stimulus has been extremely accommodative with short-term interest rates near zero and the yield curve very steep. This is producing problems for investors as money is earning a negative real return. While some market anomalies have corrected, there still remain some interesting issues for investors. U.S. ten-year government bonds yield under 2 percent while a significant percentage of the S&P 500 stock market index yields more than 3 percent. Corporate profits remain healthy
