Financial Jungle

Conventional wisdom jibes with the notion that bonds cannot outperform stocks over a distant horizon unless you’re toying with junk bonds. But there’s much more beneath the surface. I feel very fortunate to have *BondGuy, a securities broker, who promises to debunk this investment myth, but he’ll first warm us up with some background information on a special type of bonds that large institutions and the ultra wealthy invest in, namely Collateralized Mortgage Obligations (CMO.) This article is technical and lengthy, but fascinating. BondGuy is available for questions if you’re interested to learn more about CMO. Emphases in the article are mine.

* Replaced with an alias to comply with regulations.

Most of the world’s investors believe the myth that they can’t get a high yield on bonds unless they invest in Junk bonds. They take the risk of losing their initial investment if the issuer goes into default for only 2 or 3% more in interest that they receive for taking that risk. In this post we are going to bust that myth.

Where do we find the strongest credit quality?

First we need to look into finding bonds of the strongest credit quality that will give us a high level of comfort when it comes to the return of our principal. Remember folks, the return of your investment is far more important than the return on your investment. I’ll take an investment that makes a low return over a losing investment any day. Thus, we should stay away from the Junk bonds.

The United States Government and United States Government sponsored agencies hold some of the strongest credit qualities in the world. If we look at corporate bonds you will be hard pressed to find a bond that has received an AAA credit rating for 70 years continuously. Fannie Mae has been around since 1938 and has been AAA rated ever since. Freddie Mac was created in 1970 and has also been AAA rated since inception. Genie Mae is another government agency that was granted full faith and credit of the United States government in 1969 by then attorney general William Rehnquist.

AAA credit ratings are, of course, the safest available. Any credit rating below BBB is considered Junk. There are 3 major credit rating agencies that issue bond ratings in the United States Moody’s, Standard and Poor, and Fitch.

I know that many of the readers of this forum are in Canada. You can be assured that the cities that you live in invest in Fannie Mae and Freddie Mac. Not only municipalities all over the world invest in these bonds, so do pension funds, insurance companies and banks. When I started working in the bond field, some of the largest clients of my first company were banks in Europe. Freddie Mac, Fannie Mae, and Genie Mae make up the system that gives the United States mortgage market its Liquidity. If there was no Fannie, Freddie, or Genie you could go to the bank to borrow money for a home and the banker would probably say they were sorry, but they have no money to lend to you even though your credit is perfect.

When a bank gives a person a home loan they turn around and sell that mortgage to Fannie, Freddie, or Genie at a slightly lower interest rate than they lent the money at. This way the bank has a small piece of interest from the mortgage and Fannie, Freddie, or Genie has given them all of their principal back. The bank can then lend out the same money again.

Freddie, Fannie, and Genie then package these mortgages into bonds and guarantee on time payment of principal and interest. These agencies are allowed to buy very few sub prime loans and have extreme legal oversight from the United States Government. Why such tight regulations on government sponsored enterprises? If Fannie Mae, Freddie Mac, or Genie Mae were to go bankrupt it would cause world wide financial turmoil. Many of the municipalities in the world would go broke. All of the municipalities in the United States would go broke. Your pension plan would be no more (even in Canada). Banks worldwide would go under. These agencies issue and are responsible for making principal and interest payments on trillions of dollars in debt every year and have never missed or been late on a payment. They issue and pay principal and interest on more debt every year than the GDP of many counties. I think we get the idea. The credit quality is extraordinarily strong.

Genie Mae is full faith and Credit of the United States Government. Fannie and Freddie hold what we often refer to as implied full faith and credit of the U.S. Government. We just watched the U.S. Federal Reserve give a large bail out to Bear Stearns because of the negative world wide financial implications. Bear Stearns is tiny in comparison to Fannie or Freddie. The United States government would have no choice but to bail out Fannie or Freddie if they got into trouble. Thus, the term Implied full faith and credit applies to them. I think we now know how strong the credit quality behind these bonds is. Here is a credit rating chart.

Why on earth would a bond issuer with such a high credit rating pay a high rate of return?

The answer to this question is…. they don’t. The high coupons, or interest passed through to the investor in these bonds is paid through cash flow engineering. Cash flow engineering is the slicing and dicing of interest payments on the cash flows from mortgages. It’s a very complex process so we’ll give an example with some simple numbers just to make it easier for me to explain.

A bank will make mortgages at 6 ½ % to the home buyer. They will turn around and sell these mortgages to Fannie, Freddie, or Genie at 6%. So far the mortgage holder will pay the bank 6 ½ % interest plus principal due and the bank will pay Fannie, Freddie, or Genie the principal received and 6% interest keeping ½ % for their profit.

After this takes place Fannie, Freddie, or Genie will group these mortgages into what they call pools and form bonds that pass through interest from those pools. Some of these pools are in the billions of dollars. They will take 90% of these now 6% mortgages and make bonds that yield 5.5% to the investor. So what happened to the extra ½ %? They take that excess interest and pile it on top of the other 10% of the available mortgage pool giving them 51% yield on that small portion; the original 6% that the mortgages naturally pay and 45% that come from the ½ % excess off the other 90% of the mortgages. Understanding how cash flow engineering is done is not really of importance to the investor. You need to know how it works and what it does to bond coupons. You can use a car without knowing how to make one. We’ll get into what the investor needs to understand next.

Why don’t they just sell the bonds that yield 51%?

Sorry guys, it’s an efficient market that operates on the same risk return principals that every investment operates on. But, one of those risks does not have to be losing your initial investment. These bonds take interest rate risk. If rates go up, the coupon will go down and can go to zero on many of them. That’s why I buy these bonds when it looks like rates are going to go down. It’s a lot easier to speculate on rate moves than it is on stock price moves. Interest rates are in the news almost every day. The U.S. LIBOR floats right along with Fed Funds. Fed Funds is the rate that U.S. banks use to lend each other U.S. Dollars overnight. U.S. LIBOR is the rate that European Banks use to lend each other U.S. Dollars overnight. Just wait for the U.S. Federal Reserve to lower Fed Funds, the U.S. LIBOR will follow, and you can make money with these bonds.Thus, the name of these bonds is Inverse Floating Rate Collateralized Mortgage Obligations or CMO’s. Not all CMO’s are inverse floating rate, some are fixed rate and give much lower returns due to the lack of interest rate risk. Not all CMO’s are backed by government agencies like Fannie, Freddie and Genie. CMO’s that are not backed by Fannie, Freddie, or Genie are subject to losing money due to defaults in the sub prime market.

If we want to take risks to get a higher return we should take interest rate risk and always buy the CMO’s that are backed by government agencies. I have bonds in my client portfolios that float inversely to the 1 Month U.S. LIBOR anywhere from 2% to 25% for every 1% that the index moves. This percentage is called the lever. The Federal Reserve has lowered rates from 5.25% to 2.00% since October 2007. Thus the bonds that have the higher levers are getting about 60% coupons currently.

As rates go up the coupons on these bonds will go lower at the same rate that they went up. All inverse floating rate bonds have what we call a strike. The Strike is the point on the LIBOR Index where the bonds coupon will hit zero. If you have a bond with a 4.5% strike and rates are at 4.75% this bond is considered out of the money and will not begin to pay interest again until rates are lower than 4.5%. After rates fall below 4.5 the coupon will increase by the lever amount. For example: If we have a bond with a 4.5 strike and a 15 lever and rates fall from 4.75 to 3.5% over the next several months the interest rate paid to the investor will go from 0% to 15%. If rates go back up over 4.5% the coupon will go back to 0%.

What are the Maturities on these bonds?

We never know what the maturity on a CMO will be. They are made up of 30 year mortgages and the principal and interest payments are passed through to the investor every month. Usually, they take 7 - 12 years to come to maturity.

If they are 30 year mortgages how do they only take 7 -12 years to come to maturity? The average U.S. family lives in a house for 7 years and the home is sold, effectively ending the mortgage contract. The investor receives their principal on that portion of the bond every time a mortgage contract comes to an end. We have what we call the 4 D’s in this market: Divorce, Death, Destruction, and Default. If a couple gets a divorce the home is usually sold. The same happens when someone dies. If a home is destroyed the insurance company pays off the remainder of the mortgage and the contract is over passing that principal on to the investor. If someone defaults, that mortgage contract is done, the bank takes the house, and the investor in the CMO is paid their portion.

Let’s not forget that on time payment of principal and interest is guaranteed by the U.S. government or a U.S. government agency when you buy bonds issued by Fannie, Freddie, or Genie. Another big factor that causes these bonds to pay down faster is refinancing. If a mortgage holder refinances their mortgage the contract is over and the investor in the bond gets that portion of their principal back. Refinancing happens when rates go down and mortgage holders are given the opportunity to refinance it into a lower interest rate.

There are several factors that an investor looks at to estimate when the bond will come to maturity. The first number they would look at is the weighted average coupon, which is the average rate to the mortgage holder. If they have a higher rate they will be more likely to refinance when interest rates go down and the bond will pay off more quickly.

We look at which states the where the mortgages are located. Some states like California and Florida tend to pay down much faster due to real estate speculation. Another factor we look at is which banks made the mortgage loans. The larger banks tend to actively contact there mortgage holders for refinancing purposes. The banks make fee income and the client saves money investing at a lower rate. This also causes these bonds to pay down more quickly. Since refinancing plays a big part in the prepayment of these bonds, and most people don’t want to reinvest in a higher rate mortgage, you run the risk that rates could go through the roof and stay there for 20 years.

Let’s remember that these bonds have an interest rate paid to the investor that floats opposite interest rates. If rates did go through the roof for 20 years you could be holding a non-performing asset for that amount of time. It’s never happened before but the possibility does exist.

How does Bond pricing work with the inverse floating rate CMO?

If interest rates rise, the price on bonds goes down. If interest rates fall, the price on bonds goes up. Since the coupons on inverse floating rate CMO’s can float so far from where market rates are, they have much higher price volatility than normal bonds. If rates are down, I’ve seen some of the higher leveraged bonds priced at 175 cents on the dollar when I only paid 100 cents on the dollar for them several months before. When rates go up I’ve seen these bonds priced at 50 cents on the dollar.

Investing with a bond investor mentality is far different from that of a stock investor. You know that if you hold your bonds to maturity you will get all of your money back as long as we are using government or government agency bonds. If your stock portfolio is down for the month you feel bad, you don’t know when your stock will come back to the price that you paid for it. When you are investing in bonds you have a contractual agreement to give you all of your money back at some point in the future. Not to say I don’t sell on some highs but I don’t worry at all about the lows. The price will come back when rates go back down and we always receive our principal at 100 cents on the dollar. Many of these bonds can be bought at 50 cents on the dollar if rates have gone up and when rates fall the price will go up making a nice buy and sell play. Let’s not forget that when the price goes up, this means we are being paid interest again. If we sell we get the interest up to the point when we sell the bond and the gain form the sale of the bond. I’ve seen 80% returns with this play.

There are other bond plays that can make nice returns.

CMO’s come in many different varieties. We can use Two Tiered Index Bonds (TTIBs) which are CMO’s that will give us a return higher than most junk bonds with AAA credit ratings. Again we will take interest rate risk. With TTIBs we will receive an interest payment until the 1 month LIBOR reaches a certain rate. As of late I have been seeing bonds that will give the investor 7.5% until the 1 month U.S. LIBOR reaches a 6% strike price and then it will start to go down, 8% until the 1 month U.S. LIBOR reaches a 5.5% strike and some that will give the investor 9% until the 1 month U.S. LIBOR reaches a 5% strike. The coupons could fall to 0% if the U.S. LIBOR goes over the strike price.

Another play that many retirees make is in floor bonds. They are inverse floating rate bonds that will give you a minimum coupon and will float up and down inversely 1% for every 1% that the 1 month LIBOR moves. Why would we buy a 6% bond if we could buy one that will give us a 5% minimum but has the potential to give us 10 – 12% at times.

I understand that many of the readers on this site are from Canada. If you invest in this type of bond you will also be subject to currency risk. I am not a currency trader nor do I believe that I have the expertise to inform you about currency risk. I know that currently the U.S. dollar is sliding against foreign currencies. If you plan to invest this type of bond make sure you speak in detail with your financial advisor about inverse floating rate Collateralized Mortgage Obligations before hand. I would be surprised if there is not an equivalent to CMO’s for the Canadian bond market. Unfortunately I don’t know anything about Canadian government issuers but I can’t see a country like Canada doing without them. If you wish to invest in the U.S. bond markets please wait until the price of oil comes down and the U.S. Dollar stabilizes. For those readers who live in the U.S. you have no foreign currency risk.

Today, I was approached by Dave Coleman who is a lead Community Advocate from a new social lending player, CommunityLend.

The whole concept of social lending is relatively new to me. In a nutshell, CommunityLend is an online marketplace that brings ordinary lenders and borrowers like us onto an efficient and nimble platform, thus bypassing most of the overheads from traditional banks and credit unions. This would ultimately leave a lot of money on the table.

“Share the wealth,” CommunityLend pledged.

Borrowers stand to benefit from the best possible rates with multiple lenders competing against each other to bid down the interest rates. Once an auction hammer strikes, the unsecured loan is directed to borrowers’ account, and repayments are automatically deducted every month. To learn more about becoming a borrower, visit I Want To Borrow.

Lenders also benefit because according to CommunityLend, “To keep things as safe and secure as possible we will use virtually the same processes and service providers as banks and credit card companies use for validating identity, sourcing credit information, moving money between parties and enforcing collections.” You can visit the I Want To Invest page to learn more about becoming a lender.

As far as I know, CommunityLend is the first of its kind in Canada, and they’re not even open for business until mid-2008. But apparently, social lending is proving to be a smash hit in countries such as UK and US. UK-based social lending mogul, Zopa, has a member base 190,000 strong across UK, Italy and US, and they’re marching into Japan. According to Zopa, the average return for lenders is 8.1% with a stunning 0.1% default rate.

Since CommunityLend’s website isn’t fully functional yet, you can get an idea of what the auction screen might look like at US-based Prosper. Here you’ll see a list of loans each describing the purpose of the loan, borrower’s credit rating, current bid, and amount funded so far. If you need another example, check out Lending Club.

Dave wanted to know my first impression of social lending. I think it’s a good idea to have new competitors against banks to fight for our dollars, but I still have the following questions/concerns:

1. How does CommunityLend get paid?
2. What happens when a loan defaults? Will CommunityLend fight for the lenders?
3. Can lenders diversify by slicing their money into different loans?
4. How do lenders and borrowers determine what’s a justifiable interest rate for a particular credit score? Is there a primer available for lenders and borrowers to educate themselves prior to an auction?
5. Can a lender back out before the term is over? Can he sell the loan to another lender?
6. What’s the anticipated ratio between the number of borrowers and lenders?

[Edited Apr 12, 2008]

Disclosure: I’m not affiliated with CommunityLend. This is not a paid post.

Additional readings:
* Social lending the next Web 2.0 phenomenon
* Social lending set to soar
* Looking to become ‘an Ebay for loans’

1. 80% of our net worth is our ability to earn income - Our investment portfolios extend well beyond just the securities in our brokerage accounts; our greatest asset is the ability to learn new skills and to become productive citizens of the sociaty. In my opinion, the ability to earn salaries is simply bonds on steriod. I guess you can say my name is Bond. Since 80% of our net worth has bond-like characteristics, we don’t intend to overweight bonds. Instead, we let the remaining 20% ride a diversified basket of dividend-paying stocks. Critics will point out that we could lose our current jobs tomorrow, but then we simply go find another one. Jobs are plentiful as long as we’re not choosy. The only caveat is the transition. The best way to protect against short-term job interruptions is to reserve 6 months worth of emergency cash. For long-term protection, buy disability insurance.
2. Bonds are extremely tax-inefficient - The government taxes our bond income ruthlessly at our marginal-tax-rates. We can circumvent that by hiding our bonds inside RRSP, however our RRSP accounts are too precious! We rather decorate our RRSP with high-quality income trusts (e.g. Canadian Oil Sand) and US dividend-paying stocks than squandering a penny on low-yielding bonds.
3. Bonds have miniscule real growth - The current 10-year government bond offers 3.8% yield. Subtract about 2.2% in inflation and 1.2% in income tax, we’re left with 0.4% real return. That’s a steep price to pay just to tame volatility…
4. Bonds don’t make our portfolio safer - According David Dreman, author of Contrarian Investment Strategies, “The major risk is not the short-term stock price volatility that many thousands of academic articles have been written about. Rather it is the possibility of not reaching your long-term investment goal through the growth of your funds in real terms. To measure monthly or quarterly volatility and call it risk - for investors who have time horizons 5, 10, 15, or even 30 years away - is a completely inappropriate definition. The volatility measurements provide only an illusion of safety.”

The mortgage facilities are offered at various banks. You can choose any buy to let mortgages deals. The most used facility is the home mortgage facility. If you need more loans then there is an option of bank home loan 2nd mortgage available. The free insurance quote will provide you the required estimate. All insurance companies accept the online credit card. Many people are investing in this business due to high insurance carrier and scope.

Sure, you can invest in this 3-bedroom Vancouver old timer yielding a meager 3.5% to 4% CAP, but why torment yourself? Instead, you can indulge yourself with an 8.2% yield by owning these sexy office towers within H&R REIT’s portfolio:

As you may recall, the market has been punishing the Real Estate Income Trust (REIT) sector for much of 2007 and into early 2008, while the average yield is inching up each day. No one knows how long the spanking will persist, but as of this moment, the whole sector is roaming into bargain territory as many REITs are yielding well above 7%. That is far more attractive than the 3.74% offered by Canada 10-year bond, a popular yardstick to judge how attractive the REIT sector is relative to a guaranteed income investment.

I have taken an interest in H&R REIT - the largest Canadian office REIT and the overall second largest Canadian REIT behind RioCan. Today, HR.un is distributing an annualized $1.44 or 8.2% based on closing price of $17.49. That looks pretty cheap to me, and insiders agree. CEO Thomas Hofstedter and directors collectively scooped up $3 million worth of units in Nov & Dec at prices above $19. I picked up half a position at $18.05, but if we’re lucky enough, the trust will trade below $16 for a 9% yield. Otherwise, I’m happy to hold on to the half position for the long haul.

Back in 1999 when euphoric investors were dumping REITs while flocking to the ecstasy of dot-com land, HR.un traded briefly above a 12% yield at a time when 10-year Canada bond was yielding 6.25%. Outside of this anomaly, HR.un’s yield was around 10%, or a 4% premium above Canada bond. Today, the market is giving us a second chance to own this REIT at a 4.5% premium above Canada bond.

HR owns a portfolio of 35 office, 125 industrial, and 142 retail properties across Canada but principally in Ontario. Some of their well known creditworthy tenants include Bell Canada Inc., TransCanada Pipelines, Bell Mobility, Telus , Royal Bank, Public Works of Canada, Nestle, Canadian Tire, Finning International, Circuit City, Rona, Lowe’s, Shell Oil Products, Home Depot, Wal-Mart, Chapters, Famous Players, Walgreens, Sobey’s and Shoppers Drug Mart.

The trust has steadily bumped their distribution over the years, rising from $1.03 in 1998 to $1.44 today, or an annualized 3.8% growth. (They just increased distribution by 5.1% this month.) Together with the 8.2% yield, that’s a total return of 12%. Not too shabby for a hard asset class that’s traditionally weakly-correlated with the stock market. And if you’re into DRIP, HR offers a 3% bonus if you reinvest the monthly distribution to buy more units.

Real estate, by nature, is a highly leveraged asset class. HR’s average mortgage term is 10.4 years, but this is paired with an average tenant lease duration of 12.2 years with only 12.8% of leases expiring by the end of 2012. Nothing is bullet proof, but mortgage payments appear well covered. Nimble management was quick to snap up cheap buildings in a hot real estate market. New properties acquired during the first 3 quarters of 2007 cost the REIT a weighted average mortgage interest of only 5.67%, giving them an expected levered return on equity invested of 12.1%.

The only thing peculiar about HR is that their payout ratio actually exceeds 100%. The portfolio released $133.2 million of cash during the first 3 quarters of 2007, but distributed $133.7 to unitholders. This practice appears normal judging from other landlords in the REIT space. For example, bellwether REIT, RioCan has a shocking 116% payout according to a TD Waterhouse report. My only explanation is that REITs with a deeper pipeline can afford to over distribute in the short-term; RioCan has 10 properties in the pipeline versus HR’s 3.

** This is not a recommendation to buy. I’m not a REIT expert. If you have an opinion on HR or REITs in general, I’d love to hear about it.

For more info, please visit www.hr-reit.com.

There are different debt management companies, which want you to free from debt. You can learn from different websites that how to pay debt easily and can provide you every type of debt help. Now you can get online insurance leads by different companies and also online mortgage services. Low bank home loan rates are being offered by a number of banks. The home insurance is also available at cheap rates making it easy to pay installments.

My parents called the other day reminding me to cut back on dividend investing and start securing a house for our future. A house is a hard asset that always goes up, they reasoned, but stocks are just pieces of paper which can vapourize into thin air.

Predictably after the call, I was in no hurry to scamper to the real estate parade and satiate realtors with fat commissions. Contrary to the popular belief, hard assets do stand firm behind stock certificates: factories, equipments, pipelines, phone towers, cheese, hot water tanks, railways, trains, pills, hydroelectric plants, customers, revenues, profits, bank accounts and many more. Moreover, real estate doesn’t always go up. Suppose you bought a home in Vancouver during the peak of 1980, it would have taken 26 years to recover your money.

However, I must concede that our net worth is running dangerously low on real estate. What should we do? Perhaps we should buy stocks with real estate on the balance sheet. That’ll drive the parents crazy.

When it comes to real estate stocks, Riocan tends to balloon to the A list. That’s because Riocan is the de facto alternative for frugal investors wishing to save the 0.55% MER on the iShares CDN REIT sector index fund; Riocan commands 24.4% of the fund. The flip side of the coin is that this artificial inflated price premium is hard to justify considering Riocan’s 6.3% yield is well below the average (~7.6%), while their distribution growth hasn’t exactly raced ahead of the pack.

Rather than placing all my real estate eggs in Riocan, another option is to diversify the cash between Calloway REIT and Brookfield Properties. That way, I get exposure to both retail and office properties.

Calloway’s success is riding on the ferocious Walmart invasion into the Canadian retail market. Over 100 Calloway malls are anchored by Walmart who are contributing over 25% of Calloway’s total rent revenues. According to Andrew Guy of Sentry Select, Walmart is a tough negotiator. But having their presence serves as a super magnet attracting foot traffic and secondary tenants to the retail stores. With 125 retail properties under its belt, the trust isn’t that much smaller than rival Riocan’s 208. REIT expert, Dennis Mitchell, forecasts Calloway to surpass Riocan as the largest REIT in Canada within 2 years. There are many more reasons to like Calloway: it’s trading approximately 15% below NAV, the 6.7% yield is higher than Riocan’s 6.3%, and it’s been raising distributions at a vigorous pace. Expect more of the same from Calloway as it’s laying the foundation with 15 properties in the pipeline for development versus Riocan’s 10. Additionally, 92% of total properties are little babies, all of which younger than 13 years.

When you buy Brookfield Properties, you become a proud owner of trophy office assets around key metropolitans in North America, most notably New York. CEO Ric Clark projects a 50% increase to operating profit from the current development pipeline, but that’s before plowing their way to become the lead contender to win the Manhattan-based Hudson Yards project which should pad another 30% to 40%. The Hudson Yards project would be an image booster according to Sinclair Stewart, “[Brookfield Properties] is widely regarded as a formidable office landlord, with a portfolio of roughly 100 properties that punctuate the skylines of New York, Los Angelas, Toronto and Boston, … As a developer, however, its credentials are far less certain… The Hudson Yards would change that perception overnight, conferring instant credibility, nearly doubling the company’s development portfolio.” So far this year, the lingering concern over Merrill Lynch’s upcoming lease expiration sent the stock tumbling 50% from its peak in February. According to Dennis Mitchell, Brookfield is sporting a juicy 25% discount to NAV. BPO offers common shares yielding 2.8% of pure dividend.

Admittedly, real estate stocks are notoriously challenging to analyze due to the ever morphing balance sheets. What are you thoughts on these 2 real estate trust/stock? Do you have suggestions on how to approach real estate investing?

You can now check frequently asked questions and answers for mortgage basics information. The mortgage calculator and the amortization table help you to check the extra payments on mortgage. Several buy to let mortgages offers are very attractive for the landlords and others who are interested in real estate specially. Now banks easily provide home loans with out any home mortgage. Different kinds of credit cards are also available with loans.

I’ve recently picked up a couple of non-financial income trusts: Inter Pipeline and Boston Pizza Royalty Income Fund.

Inter Pipeline Fund

You can read about Inter Pipeline in my How To Pick Pipeline Trusts post, where I highlighted their key assets as well as their strong and growing free cash flow. Interestingly, The Vancouver Sun has an article on Not enough pipeline for surging oil production, regular says.

The National Energy Board said the pipeline industry may face a capacity crunch as oil output this year rises to 2.9 million barrels a day, nine per cent more than in 2006. Almost all new Canadian oil comes from the oilsands region of northern Alberta, where more than $100 billion worth of projects to exploit reserves are planned or underway.

Boston Pizza Royalty Income Fund

Onto Boston Pizza Royalty Income Fund, this is my very first restaurant investment. The fund owns the Boston Pizza trademarks and licenses them to a private corporation, Boston Pizza International (BPI), for a 99-year term. In return, BPI compensates the fund with 4% of franchise revenues from 266 Boston Pizza restaurants across Canada. The beauty of this “top-line” funneling is that the fund enjoys a stable and consistent cash flow with no dependency on the restaurants’ profitability. Their cash flow statements are an eye-opener — no capital expenditures! BPI and their franchisees incur all the maintenance and expansion costs, while the fund gleans 4% off their total sales.

There are few contenders in the restaurant royalty space, which includes A&W Revenues Royalties, Pizza Pizza and The Keg Royalties Income Fund. However, Boston Pizza Royalty stands out of the pack with their higher liquidity (about 4x the others), generous yield (9.5%) and best-in-class same-store-sales-growth (6.5% over 10 years).

Same-store-sales-growth (SSSG) is crucial because that’s the main driver behind the fund’s distribution increases. The fund went public in 2002 with an initial monthly distribution of $0.0833, but has since risen it 12 times to $0.1130 for an annualized 6.36%, which is in line with the 6.5% SSSG.

Between the 9.5% yield and 6.36% growth, my expected internal rate of return is 15+%. The trust is trading at around $14.50 while distributing $0.113 per unit per month. This is a much better value than when it was trading at over $20 before Halloween. Back then, it was distributing only $0.109 per unit per month.

The distribution is about 84% taxable, so it’s more tax-efficient to hold the fund inside RRSP. Short of that, the second best option is to hold it under the spouse with the lower tax-bracket.

Reference:

• Boston Pizza Royalties Income Fund Fact Sheet
• Frequently asked questions

Alright. Maybe I can fit a little sequel to the income trust series.

I’m not sure if anyone noticed, but there is a distinct divergence between prosperous and crummy trusts in the aftermath of the income trust tax ruling. The prosperous ones continued to flourish, while the crummy ones never quite recovered to their roaring days.

You heard of the old saying:

A rising tide lift all boats

As long as everyone was happy about receiving their 10+% yield, no one was questioning the sustainability of the underlying foundations that supported these yields. Alas, all good things must come to an end. The tide came and went. The Halloween upheaval exposed so many little elusive holes beneath some of the rottenest boats. The tax ruling announcement turned investors’ stomachs, and sure enough, most trusts retreated 15-20% the next morning.

As painful as it may be, I think Ottawa’s decision to plug the tax leakage was a blessing in disguise as it forced out the excess speculation in the trust market. Even the most relentless critics must admit; investors today (including myself) are more attentive to the quality of trusts. This is good! It serves as a wake-up call. Fussy unitholders put their trusts in a spotlight and make management more accountable to their actions. Wouldn’t you rather suffer a healthy 20% haircut today, than having your 10% yield tab shut tight during your golden years?

What do I mean by prosperous and crummy trusts? To illustrate, let’s contrast 2 strikingly different trusts: Canadian Oil Sand and Vault Energy Trust .

Now scrutinize Vault Energy 2006 cash flow statement and balance sheet. Folks, this is a textbook income trust that forensic accountant, Al Rosen, would love to hate!

• The $45.61 mil cash flow from operations is too cute when standing next to the $88 mil from capital expenditures and cash distribution.
• Switching over to their balance sheet, total assets are falling, total liabilities are rising, thus book value is falling.
• Outstanding shares are rising, which further dilutes the existing shares.

Still think all trusts are created equal?

One great reward about being a blogger is the new insights you gain from researching and presenting articles. It’s one thing to skim over the Internet for the lowdown of income trusts, but quite another to articulate them to an audience. So much to learn still despite spending a couple of evenings on O&G trusts. Well, this post wraps up my part on the income trusts series initiated by Thicken My Wallet. I hope you’re enjoying it so far.

Saving the worst for last, oil and gas trusts are probably the most provocative group of all.

O&G trusts are holding structures that own the right to royalties on the production of natural reserves. These trusts do not engage in explorations. Instead, they negotiate and buy royalties from exploration companies. These exploration companies will generally stay behind to manage the production, but the trusts and their unitholders own the right to the stream of profits from the reserves. The one key difference between investing in O&G trusts and most other investments is that at the end of the day, your equity vanishes! Poof! Your objective is to squeeze every drop of your money back from the reserves, and hopefully a little more to compensate you for the risk-taking.

On the surface, O&G trusts have few bright spots:

• No exploration risks
• Reserves are well known
• Productions are well known
• Operation costs are well known

Alas, these trusts also come with a number of caveats; one being the limited lifespan of these reserves, many of which will not survive more than 10 years. In order to nourish the cash distributions to unitholders, the trusts must continuously replenish depleting reserves through new acquisitions. Huh? New acquisitions? Where are the down payments coming from? Through share issuances and debt financing of course. This part bugs me the most. This arrangement is reminiscent of the Ponzi scheme, where money from new investors is scrounged to maintain distributions to existing unitholders. The tale doesn’t end here, because the new reserves, as their predecessors, also have a limited lifespan. Saving investors from the agony of waning income, the trusts must dig themselves into deeper holes by tallying up even more investors and even more money to fund even more new reserves.

This illustrates the fundamental flaws of this trust model. No rational investor will want to share her profits when she’s the one risking her money on the line. If she’s the rightful owner of the new oil wells, she deserves all the cash flow produced from it.

Our anxieties shouldn’t end here. In addition to the dwindling reserves, investors must be conscious of future oil and gas prices. For instance, the price of crude oil today is $75 which is near its historical high. If the production cost per barrel of oil is $45, one may project a margin of $30 per barrel until all the reserves are depleted, but this is not a sure thing. A mere $10 drop per barrel would evaporate 33% of the profits. Even a cursory understanding of the intricacies behind oil and gas trusts explains why cash flows from O&G trusts can be erratic over time when compared to bonds. Oil trusts achieve high levels of operating leverage as their production costs are largely fixed no matter what the crude oil price is. Profits are a function of the prevailing crude oil price. As oil price diverges from costs, profits expand. Conversely, as oil price gravitates toward costs, profits erode. The lowest cost producers have the best competitive advantage against price volatility.

Finally, O&G trusts are very interest rate sensitive, as with all income trusts. This is a given.

With these caveats in mind, I’ve compiled the following criteria to help jump start your search if you’re extremely bullish on energy prices.

• Long-life reserves - Keep the distributions coming longer.
• Low(est) cost producer - Profits from the lowest cost producers are the least sensitive to energy prices. Likewise, a small dip in oil prices can wipe out all of profits from the least efficient producers.
• Clean balance sheet - The less debt on the balance sheet (low Debt/Equity ratio), the less sensitive it is to interest rate fluctuations.
• Low payout ratio - This is especially true for O&G trusts that engage in Pac-Man acquisition sprees.

Example: Canadian Oil Sand

If I were to invest in an oil trust, it’d probably be Canadian Oil Sand. It owns a 37% interest in the Syncrude project, a pure play in an oil sand that has stunning reserve life of 40+ years. I believe the slow depletion rate is confirmed by the miniscule 3% in of Return of Capital. The trust also sports a healthy 0.36 Debt/Equity ratio and 55% payout ratio, notwithstanding a weak 4.9% yield. Based on some preliminary readings on their web site and StockChase.com, they have just completed the third and final stage of their Syncrude 21 expansion. With capital spending behind them, analysts expect distributions to rise this and next year subject to oil price remaining at a high level.

According to Syncrude, their operating cost per barrel is $26.46 in 2006. That’s pretty cheap! Perhaps I’m missing something, but there is an enormous margin between the operating cost and the market price of $75 per barrel. The dual of low debt obligation and efficient production should yield some breathing room from external crisis such as deteriorating oil price and soaring interest rates.

Other Oil and Gas Trusts

• PenGrowth Energy
• EnerPlus Resource
• Bonavista Energy
• Crescent Point Energy
• Harvest Energy

Additional Resources

• In case you’re interested, a video of the oil sand production process is available here: “How We Make Oil at Syncrude”
• Hot idea fuelled energy trusts - A nice history on energy trusts.
• To keep abreast on the current energy prices, visit Bloomberg.

Pipeline trusts are terrific additions to any diversified portfolio; their cash flows are generous, predictable and sustainable. When you buy a pipeline trust, you’re buying a combination of long-lasting energy infrastructure cash-cow machines used to transport and store oil and gas. Many pipeline trusts are involved in some of the largest and longest-lasting oil projects in North America, thus enabling them to secure long-term contracts to transport oil from productions to refineries.

What are some of the key characteristics of pipeline trusts?

1. Strong competitive advantages from high barriers to new competitions due to hefty capital costs, government regulations and brands.
2. Pipelines have longevity and low maintenance.
3. Revenues are largely fixed while capital expenditures are minimal. (Translation: reliable cash flows)
4. Not much growth potential. Buying at the right price is crucial, because you don’t want to be stuck with a low yielding and slow growing investment.
5. Unlike oil and gas production trusts, pipeline trusts’ transportation revenues are generally decoupled from commodity prices.
6. Since pipeline trusts must compete with other income-based securities, share prices are sensitive to the prevailing interest rates.

What to look for in a pipeline trust?

• Squeaky-clean balance sheets - We want to turn away trusts burdened with massive debts on their balance sheets. Trusts with conservative capital structures desensitize themselves from rising interest rates, and give them little wiggle room to expand. The key ratio to look for is the Debt-to-Equity ratio. Here are several examples: Inter Pipeline (0.56), Pembina Pipeline (0.75) and Fort Chicago Energy Partners (1.99 - ouch!)
• Positive cash flow - As with all income trusts, ensure the pipeline business generates enough money to maintain existing infrastructures and to pay us cash distributions. Normally, I’d glance over the cash flow statement from MSN Finance, but there underlies a problem; capital expenditures lump both maintenance and expansions together. Since a few of the major pipeline trusts, likeInter Pipeline and Pembina Pipeline) are currently in expansion mode, I have to discern maintenance from other growth initiatives. Otherwise, MSN Finance will confuse me into thinking that these trusts are bolstering the distributions with new shares and debts — a very yucky situation. There are no short-cuts. Investors must download and soak up the annual reports to separate out the maintenance expenses.
• Payout ratios - This goes hand-in-hand with the positive cash flow criterion above. The lower the payout ratio, the safer the distributions. Do not blindly accept the payout ratios from third-party sources, such as MSN Finance, due to discrepancies in how distributable cash flows are calculated. It’s best to crunch the payout ratio yourself. An example is coming.
• High S&P Stability Rating - A trust with a high S&P stability rating has a better chance of sustaining the distribution. Most of the high quality individual trusts have an SR-2 rating, whereas “portfolios of funds” tend to have the SR-1 rating. Some of the SR-2 rated trusts include CML Healthcare, Pembina Pipeline, RioCan and Yellow Pages. It’s too bad that S&P doesn’t rate all the available trusts. However if a trust is listed and it’s below SR-2, don’t bother investing.

Example: Inter Pipeline

There are several popular pipeline trusts at your disposal, but I’ll pick Inter Pipeline since Money Gardener has been nagging me a couple of times. When you buy Inter Pipeline, you become part-owner of the following enduring assets:

• 5,900 kilometres long of petroleum pipelines (Four conventional oil pipelines, and two oil sand pipelines).
• 3.6 million barrels of storage in western Canada.
• The above assets pipe 822,000 barrels per day of oil sands bitumen, conventional crude oil and gas plant condensate, with a market share of 18% in western Canadian conventional volumes and 50% of oil sands volumes. These represent 44% of earnings.
• 3 major natural gas liquids extraction facilities in southern Alberta on the TransCanada system. These facilities are processing 4.2 billion cubic feet/day of natural gas and producing 142,100 barrels/day of natural gas liquids for now, but have the capacity to process 6.2 bcf/d of natural gas, and 195,000 b/d of natural gas liquids. (Don’t ask me what these numbers mean. ) These represent 41% of earnings.
• More impressively, their natural gas extraction facilities are responsible for processing 40% of Alberta’s natural gas export.
• 9 bulk liquid storage terminals in UK, Germany and Ireland. These represent 15% of earnings.

You can find Inter Pipeline’s distribution history here. As of this writing, the trust is trading at $9.51 with an 8.85% yield. The distribution is 85% taxable with remaining as tax-deferred capital gains (return of capital). Do keep in mine that although unitholders have been indulged with a bountiful yield, in exchange, they settled with an uninspiring 3.2% distribution growth rate.

Inter Pipeline has a positive cash flow. According to the cash flow statement, operational cash flow in 2006 is $201 mil. At first glance, this cash flow doesn’t cover the $160 mil cash distributions to unitholders and the $65 mil in capital expenditures, but wait. As I alluded to earlier, part of the capital expenditures is assigned to growth. According to page 40 of their 2006 annual report, only $5.6 mil was “sustaining capital expenditures”. The effective payout ratio after sustaining capital expenditures is around a healthy 82% ($160 / [$201-$5.6]).

Unfortunately, S&P doesn’t have a rating on Inter Pipeline.

Valuation wise, the best two times to buy Inter Pipeline were in 1999 when investors were flocking to growth oriented technology stocks, and in Nov 2006 when Finance Minister, Mr. Flarity, detonated the Halloween bomb on taxing income trusts. Moving forward, I don’t see any more corrections in the horizon unless Bank of Canada hints further hikes are lurking beyond Sep 2007. The units have settled in the range of $9.00 and $9.80 and trending upward. The trust is suited for RRSP, because the tax on distributions can be deferred inside in registered accounts.

Disclosure: I don’t hold Inter Pipeline nor any other pipeline trusts. As always, I’m an amateur investor. Do not buy or sell securities based solely on the information provided on this site.

Examples of other pipeline trusts:

• Inter Pipeline
• Pembina Pipeline
• Fort Chicago
• AltaGas Income
• Gaz Metro
• Keyera Facilities

I’m collaborating with Thicken My Wallet and Million Dollar Journey to compose a series of posts on income trusts investing. Thicken My Wallet is leading the series with a bird-eye’s view on the financials such as payout ratios, cash-flows, capital expenditures and financing. I recommend you visit his introductory post, and then follow his links to the different categorizations of income trusts by Million Dollar Journey and me.

The traditional sense of business trusts is slow-growing mature businesses in the manufacturing, service or general industrial sectors. They typically produce stable cash-flow and distributions to trust-holders, which is why yield-starving investors are finding the distributions from business trusts irresistibly tempting. However, critics are warning that a majority of business trusts are sprinkling only small amounts of genuine income from operations, while a significant amount (over a third) of the distributions are simply return of equity.

Return of equity is the original capital returned to investors. For instance, suppose you invest $10 in my business. When I take $1 out of the pool and give it back to you, that’s a return of capital. You get your dollar back, but your investment is now worth only $9. Obviously, this magic show can only sustain until there’re no more rabbits in the hat. It’s crucial for investors to scrutinize the distributions beyond the yield percentage. Often, a trust yielding 6% has fortified growth profile and solvency, but another is upholding its 15% yield using cash from new share issuances. Some people call this scheme Ponzi, where the business tallies up cash from new investors to maintain the distribution.

Here at Financial Jungle, we shun away from return of capitals, and favour only exceptional business trusts that produce sufficient cash-flow to fund all of maintenance expenses, income distributions and growth. One such fabulous trust is North West Company fund (NWF.un), which constantly brings me tears of joy whenever I admire its filthy rich cash flow statement. Here are some criteria I’m looking for:

• Cash from Operating Activities - This is a summation of all the cash generated from the business’ operations. Although an up trend is a must, investors must ascertain the quality of the operational cash-flow to rule out any anomalies within. For examples, is the trust producing a humongous cash-flow by deferring tax obligations and/or not replenishing working capital? Investing Skeptically lead me to this article by the ferocious Al Rosen. In his words,
  
  

  We tell our institutional money-managing clients that all cash flow mistakes result from the arbitrary timing or classification of management actions or inactions.

  I believe one method of rectifing the disparity of timing is to measure the trend over multiple fiscal years instead of snapshotting one year. Looking at North West Company fund, the operational cash flow looks reasonably clean: income is rising, depreciation is stable, and working capital evens out over time.

• Cash from Investing Activities - The crucial factor is capital expenditures. Capital expenditures are investments made by the trust to maintain or grow the operations through purchases of physical assets such as property, industrial buildings or equipment. Trusts with capital expenditures greater than depreciation indicates that they’re replacing depleted assets as well as increasing capacity to stimulate operation growth.
  
  

  North West Company fund depreciated their assets by $120 mil over the previous 5 years. During this time, they reinvested $130 mil back to the business.

• Cash from Financing Activities - Total Cash Dividends Paid is arguably the most cherished figure by income investors; this is the actual cash distributed to trust holders. Any high-caliber business trust will fund this distribution internally with surpluses from operation after replacing depreciation.
  
  

  For instance, North West Company fund has $81.49 mil from operational cash-flow in 2006. Depreciation is $26.17 mil. That results in a surplus of $55.32 mil, which is more than enough to satisfy the $38.7 mil distribution. In fact, the trust has enough cash left over to expand its stores (capital expenditures > depreciation), buy back some shares (retirement of stock by $1.53 mil ), and repay some debts (retirement of debt by $5.57 mil).

Needless to say, I’m giving North West Company’s cash-flow statement a clean bill of health. I’d love to know what you think of this post, and learn your unique angles on business trusts investing. What other criteria do you fancy in business trusts?

Examples of business trusts

• Restaurants - A&W Royalties (8.7%), Boston Pizza (9.2%) and The Keg (8.8%)
• Transportation - Transforce Income (11.0%) and Contrans Income (11.0%)
• Retails - North West Company (5.6%) and Sleep Country (5.9%)
• Health Care - CML Healthcare (6.5%)
• Specialities - Versacold Income (8.2%), SFK Pulp Fund (11.8%)
• Media and Telecommunication - Yellow Pages Income (7.6%) and Bell Aliant (8.8%)

Folks, I’m on a quest to nail down a checklist for income trust investing. The checklist itself is an evaluation, and one reason for this post is to solicit your feedbacks and hopefully morph the list into something functional.

The unfortunate reality is that our Canadian common share market is quite narrow when it comes to selections, but the income trust market opens a door to a new dimension of diversification. I maintain a small watch list of income trusts, and it’s quite intriguing watching most of them going against the TSX movements on a regular basis. You know you have a healthy portfolio when all your securities are weakly correlated with each other.

Although I’m not one to stereotype, somehow there’s a stigma and prejudice against income trusts as being no growth businesses that keep chugging steams of cash while draining down their assets. Since I’ve not analyzed every single trusts out there, I can’t confirm if the majority of trusts are indeed decaying businesses, nor would that stop me from investing in this space.

Being a (wannabie) value investor, I believe it’s safer to hold only a handful of high-caliber trusts than buying the entire spectrum, which may potentially include a number of ugly cousins. By high-caliber, I mean trusts that offer at a minimum, the one-two-three knockout punch: sustainable distribution, strong growth profile, and sound fundamentals.

Without further ado, let’s sharpen our process! Please visit Canadian MoneyCentral for financial summaries, but it’s imperative that you peek under the hood by visiting the individual trust’s website. Many of which have an “Investor Relation” link to hunt down financial reports and distribution histories. For this checklist, I’ll reference CML Healthcare Income Fund, which is a leading provider of laboratory testing services in Ontario and the largest private provider of medical imaging services in Canada. (By the way, since the TSX is a Healthcare challenged index, most Canadians should consider opening their arms for home grown Healthcare stocks/trusts like CML Healthcare.)

1. Sustainable Cash-Flow - The trust must generate enough cash to cover both distributions and capital expenditures. This is one hallmark of sustainable trust distributions. If the internal cash flow doesn’t cover its distribution and capital expenditure obligations, the business must seek external funding (debts and share issuance) which is a major warning sign. Looking at their 2006 cash flow statement, the CML earned $98.4M cash from operations. In the process, they depreciated and depleted their assets by $3.28M. They have enough operational cash flow to cover both the $3.28M as well as the $78.81M distribution to shareholders without resorting to debts and share issuance.
2. Strong Growth Profile - The trust must have a strong growth profile. We’re not looking for the “good enough” trusts. To quote my ex-Marketing Director:
   
   

   We’re not in the business of pain-killing. We’re not the Tylenol; we’re the Viagra!

   Just meeting the minimum cash flow requirement isn’t good enough. We want exceptional trusts that not only reward investors with reliable distributions and, but retain the excess to propel and grow the business well into our retirements. CML’s cash-flow didn’t merely meet the depreciation/depletion and distribution, they exceeded them. What are they doing with the extra cash? Their spent $10.9M on “Cash From Investing Activities”, which is more than enough to replenish the $3.28M depreciation/depletion. In addition, they paid back $1.12M in debts and retained $2.54M in the bank. I probably didn’t pick the best example since CML’s distribution is relatively short(since 2004) but they had raisen their distribution twice.

3. Strong Fundamentals - The overall business must be sound. For instance, both the Profit Margin and Return On Capital should be higher than peers, and Debt/Equity should be manageable for the industry. There are always exceptions to the rule. For instance, it’s reasonable for REITs to have higher Debt/Equity ratios, because they can match long-term fixed mortgages with their long-term tenant contracts. CML’s Return on Capital and Net Profit Margin are 13.7% and 34.4% respectively, which are stellar for income trusts. Meanwhile, their 0.36 Debt/Equity ratio is much more conservative than the industry’s 1.39.

I have no doubt that there are gaps in my analysis. Consider this draft one. If I receive enough feedbacks, I’ll post version 2 of the checklist.

Canadian Capitalist is graciously hosting the third Canadian Tour of Personal Finance Blogs. There is no way I am passing up this opportunity to be mentioned in his blog. This will be my second participation to this tour. Enjoy!

Organizing your portfolio into neatly divided asset classes appears to be the sensible thing to do, but what if your financial advisor is offering you only a half-baked solution? Take my friend, Mel, for example. He and his wife walked in to a bank seeking an optimal way to invest a $10,000 windfall. The advisor had them fill out a Know Your Client form to learn their financial goals, risk tolerance, investment knowledge, time horizon and financial position. Based on his assessment, the advisor recommended a 70/30 split between equity and bond funds commanding a hefty 2% in management expense ratio (MER.)

What’s wrong with this picture? Like typical young couples, Mel and his wife still owe an approximate $200,000 worth of mortgage. Since homeowners pay mortgage interests with after-tax money, a 5% mortgage rate is costing Mel 7.14% of pre-tax income - assuming he’s in the 30% tax bracket. None of these bond funds could have guaranteed that rate, especially after MER. Why lend his money to a bond fund, only to borrow it back in his mortgage at a higher rate? He may as well pay down the mortgage instead of buying bonds.

The problem with the financial industry is that it’s not in their best interest if you pay down your mortgage. It’s a double-whammy for them:

• They stop collecting mortgage interests from you.
• They stop collecting MER on the bond fund.

A better solution – in my opinion – is to reduce the scope of your portfolio. Instead of investing $3,000 in bonds, pay that toward the mortgage. A dollar saved is a dollar earned. Paying down your mortgage is equivalent to earning 7.14% guaranteed. The net result is a reduced $7,000 portfolio invested 100% into equities. Sounds scary at first, but simply imagine the other $3,000 is invested in your mortgage. 7.14% guaranteed is a yield on steroid, that no one else can match.