Convertible debentures mix bond, equity advantages

Tired of low rates on fixed income investments like GICs and Government bonds?  There has been a considerable demand for higher yield, fixed income investments, in a low interest rate environment.

Convertible debentures meet the demand for investors willing to assume more risk.   They have features of both fixed-income and equity investments and are typically classified as fixed income.  But some advisors say that they are closer to equities.

The same debate exists for preferred shares, some would state they are equities.  Some say they are equities.  Others feel they have attributes of fixed income.

Similar to bonds, convertibles offer regular interest income (stated coupon rate) through semi-annual or annual coupon payments.  They also provide a degree of downside protection not found in direct equities.

Convertibles have all the standard features of a bond such as maturity date, coupon, and face value. At maturity, the face value of the convertible is redeemed by the issuer. The convertible’s denomination is the currency and minimum amount in which the bonds are traded.

Similar to equities, convertibles typically offer upside potential for capital growth.  A convertible comes with the option to convert into the issuer’s equity.  At the time of issuance, the conversion ratio is set and is usually based on the number of shares/units per 100.  The time period during which an investor may convert their debentures to stock is usually open to the maturity date.

Since convertibles are more complicated fixed income investments, it is important to read the prospectus fully to understand each issues features and conditions.   Prospectuses are available through www.sedar.com

The debt feature of a convertible debenture is derived from its stated coupon, and claim to principal.  Most Canadian convertibles are unsecured against the issuer’s assets and are not rated by credit rating agencies.  Investors should weigh the lower credit quality, against the current yield and potential to convert into equity (and benefit from capital appreciation).

The conversion feature brings with it additional characteristics and associated terminology.

For an illustration, consider common stock, ABC Oil & Gas.  ABC has issued a convertible debenture with a coupon of 6.5 per cent and a final maturity date of December 31, 2016.  ABC’s share price is currently at $9.20.  The conversion price set at issuance is $11.00.  The conversion ratio is 9.0909 shares (determined by dividing the par value of 100 by the conversion price of $11.00).  This conversion ratio and conversion price is known from the date of issuance and does not change over the lifetime of the bond.  The above convertible represents a loan to ABC, which is paid back at maturity.

Convertibles gain or lose value along with the underlying stock.  When the price of the underlying shares of ABC rises, the price of the convertible will increase as well if the share price is already above the conversion price.  Even if the shares are not above the conversion price, an increase in the common share or trust values should also benefit the debenture provided there is a greater likelihood of conversion before the maturity date.

When the share price of ABC declines, the debenture typically declines only so far before its bond-like attributes establish an effective bond-floor (even if the stock/unit price continues to decline).  Investors will continue to receive the interest income and principal repayment just like a bond and will be protected as long as the company remains a going concern.

When the stock price exceeds the conversion price, the convertible is said to be “in the money.”  At this point, it is more sensitive to changes in stock price than interest rates and trades in-line with the stock/unit price.  When the underlying stock is close to the conversion price, the convertible is said to be “at the money.”  At this point, the price is influenced by both the stock/unit price and interest rates. It will likely capture two thirds of the stocks/units upside movement with only one third of the downside.  When the stock/unit price is less than the conversion price, the convertible is said to be “out of the money.”   When a convertible is out of the money its price is less sensitive to changes in price of the underlying stock/unit and is instead dominated by interest rates and credit factors.

Convertibles perform well in rising equity markets while mitigating downside risk during market declines. They provide a more conservative approach to equities because of defensive bond like attributes. While convertibles can benefit from increases in the underlying stock price they are cushioned against stock price declines by the downside protection provided by consistent income characteristics of fixed income investments. Convertibles offer investors a higher participation in upward movements as opposed to downward movements of the underlying equity.

Convertibles may offer diversification benefits as their performance does not directly correlate to either that of equities or bonds.  Adding convertibles to a portfolio should reduce overall portfolio volatility.  Convertible debentures are typically lower investment grade (most are not provided a credit rating by Moody’s, DBRS, or S&P) and are more appropriate as part of a diversified portfolio.  We feel investors should have at a minimum a moderate risk tolerance.  Not all convertibles are equal, and some would be better classified as higher risk.

Unlike most bonds, convertibles trade on stock exchanges where the bid and ask prices are visible to all market participants. This is an advantage for most investors as it provides greater transparency and efficiency in pricing.   This also provides the ability for investors to put limit orders in to purchase or sell at a pre-determined price.

Credit risk is a concern as with any fixed income investment.  As noted above, most Canadian convertibles are not rated by the credit rating agencies. One way to gauge credit risk is to consider the creditworthiness of the issuer and examine the possibility of default.  Interest rate risk also affects convertibles just like all other fixed income securities.

 

Just how liquid are your assets?

Liquidity is a term associated with the ease in which your assets may be converted into cash.  High interest savings accounts and money market investments are extremely liquid and can be sold and converted to cash within a day.  Holding a portion of your assets in cash is important for ongoing cash flow purposes and emergency reserves.

Fixed income investments, such as guaranteed investment certificates, are typically purchased for a period of time, but may be sold in a pinch with cash raised usually within three days.  Bonds can also be sold through a financial firm’s fixed income-trading desk.

Convertible debentures, also known as convertible bonds, are fixed income investments that trade on a stock exchange and have a three-day settlement timeline.

Equities that trade on a recognized stock exchange are typically classified as fairly liquid.  Cash can generally be raised within three days after the investment is sold.  Typically one could look at the number of shares trading each day to determine the volume.

We caution any investor buying too large of a position in a company, especially a small company with low trading volumes.  It may be easy to purchase the shares but selling is often a bigger challenge.

Equities that do not trade on a recognized exchange may or may not be liquid.  Most mutual funds is whether you purchased these on a deferred sales charge basis.  If a fee or penalty exists for selling an investment, then we would classify this as “liquid for a cost.”  Structured products such as principal protected notes, hedge funds, venture capital investments, may have restrictions with respect to liquidity.  If liquidity exists then you should understand the associated costs to sell the investment.

Non-registered investment accounts should be considered more liquid than RRSP investment accounts.  Withdrawals from an RRSP account are considered taxable.  We prefer planned RRSP withdrawals rather then required withdrawals due to emergency cash requirements.  Some registered investment accounts are considered “locked-in” and have restrictions with respect to withdrawals.

There are several categories of illiquid assets, which cannot be converted into cash quickly.  In most cases, it is a result of not having a market in which it regularly trades.  An asset is usually illiquid when the valuation is uncertain.   Two common types of illiquid assets are shares of a private company and real estate.

Retirement plans are more complicated when illiquid assets are meant to fund retirement cash flows.  In some cases, these assets generate net cash flow, such as rental income.

But what happens if a roof needs to be replaced, or you have tenant vacancies?  If the real estate is financed, how will a rise in interest rates impact you?

If the majority of assets are considered illiquid, this will cause cash flow pressures at retirement.  Planning should look at the different options, including selling assets.  By planning in advance, you should be able to factor in the most tax efficient option.  It may take longer to sell an illiquid asset.  We recommend that our clients plan ahead to ensure they do not find themselves stuck, having to sell an asset at the wrong time.

To illustrate our point we will use Norman and Pauline Baker.  Norman is 66 years old and Pauline is 70.  The Bakers have a personal residence valued at $750,000 and an 18 acre parcel of land valued at over $1 million.  They have registered investments valued at $250,000.  Annually they have been living off of CPP, OAS and small registered account withdrawals.

Pauline would like to sell the 18 acre parcel of land and enjoy retirement while they can.  She knows that if they sold the property that they would never have cash flow problems again.  Norman is a retired realtor, and feels that they should hold onto the land for a couple more years so that they will get a greater value. 

The above situation highlights that the Bakers failed to factor in liquidity as part of their retirement plan.  Waiting too long to sell an illiquid asset could result in unfavourable timing, such as a depressed real estate market.  Although the Bakers have a good net worth, this has not translated to cash flow at retirement for them. 

In order for the Bakers to begin enjoying their net worth to the fullest extent they will need to sell their 18 acre parcel of land.  With the proceeds we will assist them in developing a liquid portfolio that generates the cash flow they require.

Save on your tax bill using spousal loans

Does a spousal loan sound complicated?  It really isn’t.  Most importantly, it is a perfectly acceptable strategy for couples to income split.  The purpose of all income-splitting strategies is to transfer income from the higher income spouse to the lower-income spouse, and it is most effective when one spouse earns significantly more than the other spouse.

An absolute minimum is to be in different marginal tax brackets.  However, the greater the difference in income levels the more advantageous the strategy is from a tax savings standpoint.

Another factor in determining whether a spousal loan makes sense is the prescribed rate that Canada Revenue Agency allows loans to be issued at.  Every three months the Canada Revenue Agency sets the prescribed interest rate for loans.  It is posted quarterly and is calculated based on the average yield of 90-day treasury-bills sold during the first month of the previous quarter.  Currently the rate is a historic low of only one per cent, and is guaranteed to stay at that level until December 31, 2009.

If only one spouse is working and earning a significant income, for example $150,000, then over a series of years, the only working spouse will accumulate all of the savings, say $250,000.  Unfortunately, you cannot simply gift funds to your spouse, who has no other income, to buy investments.   Wouldn’t it be ideal to put the $250,000 in non-registered GICs earning four per cent, or $10,000 a year, in the name of the spouse with no employment income?  After all, the $10,000 in income would be below the basic exemption and not subject to any tax at all.

The Income Tax Act has rules that prevent these types of transactions to take place.  These are referred to as the “attribution rules”.  In the above case, the $10,000 income would be attributed back to spouse who earned the income.  The way around the attribution rules is to lend funds to your spouse at the prescribed rate, currently at one per cent.

Here’s an example:

Mr. Walker has annual employment earnings of $130,000 and over time has accumulated $250,000 in savings.  His conservative portfolio is invested in interest bearing investments with a rate of return of four per cent.  Every year he has been reporting 100 per cent of the T5 interest income (this year the T5 was $10,000) on top of his employment earnings.  As Mr. Walker’s marginal tax bracket is 43.7 per cent, he will pay $4,370 in taxes on this $10,000 of interest income.  Mrs. Walker has been busy raising three children and has no income at all.   In total, Mr. Walker has an estimated income tax liability of $42,450 for the year.

A strategy we recommended to the Walkers is a spousal loan.  Mr. Walker could loan $250,000 to Mrs. Walker at the rate of one per cent.  Mrs. Walker could then invest the $250,000.  Using a four per cent rate of return, Mrs. Walker would earn $10,000 a year and have a schedule 4 (part IV) interest deduction of $2,500.  Her net income will be $7,500 and below the basic exemption.  Mrs. Walker will pay no tax.

Mr. Walker on the other hand will avoid the $10,000 in T5 interest income from direct investments but will have to report the $2,500 received from Mrs. Walker on the spousal loan.  Mr. Walker’s income will be reduced by $7,500 and his estimated income tax liability will be $39,173 (instead of $42,450).  We estimate an annual tax savings for the Walker household of $3,277.

To ensure the funds are considered loaned, instead of gifted, the interest must be paid by January 30 of the following year.  If Mrs. Walker does not pay the interest of $2,500 then the total income of $10,000 will be attributed back to Mr. Walker.

It is important to document the terms of the loan, generally through a promissory note.  Although this is not a requirement under the Income Tax Act, we feel it is prudent and provides appropriate evidence of the terms of the loan.  This is especially important now that the rate is currently at one per cent.  A properly executed loan document will provide clarity for specific terms, such as interest payment dates.

The prescribed rate is subject to change.  As the rate is currently at one per cent we are not expecting the rate to go any lower.  This is the perfect time to act if the strategy is suitable for your situation.  The loan terms you set can be for an indefinite, or for a specific term such as five or ten years.  Even if rates increase after you have set up the loan, the rate will remain at one per cent and stay at one per cent for the entire term of the loan.

The Walker situation above is a perfect example of the benefits of a spousal loan.  Mr. Walker is in the highest marginal tax bracket and Mrs. Walker has income below the basic exemption.  If your situation is not so clear we recommend you speak with your financial advisor and accountant to determine if a spousal loan is right for you.

Financial plans provide some clarity

We’re told over the course of our entire lives about the importance of saving to reach other goals, especially when it comes to retirement.   Most people agree that having a financial plan is important to provide clarity.

Unfortunately most people have never had a properly prepared financial plan.  For those who have a plan, few stick to it over time – especially during the down-turn we’ve all witnessed lately.

Most plans require you to gather both personal and financial information.  Your financial planner is able to input this information and generate a variety of documents ranging from a simple concept to a comprehensive financial plan.

The information you gather is mostly concrete and is based on actual amounts as of a certain date.  As well, you will have to make some projections as to the level of income you would like at retirement.  Your financial planner will also establish various assumptions or estimates (inflation rates, life expectancy, investment returns).

The best part of a financial plan is the list of savings required to meet your goal.  As an example, a typical financial plan may recommend that a couple each maximize RRSP contributions and save $500 per month in non-registered savings.   These savings are required whether we are experiencing good times or bad.

Unfortunately when markets decline, many people stop investing.  This often has a bigger long-term impact on your financial situation then for someone who continues to save.  By continuing to invest during difficult times people are essentially dollar cost averaging.  By dollar cost averaging we mean that some investments are purchased at higher amounts and others are purchased at lower amounts.

Rather than stopping the amount you save, consider saving more.  By saving more, at any time, you increase your chances of reaching your goals.

After a financial plan is prepared, it is important to update your financial planner with details of any significant changes in your life.  Significant changes may include family death, marriage, birth of child, inheritance, sale or purchase of a property, significant raise, job loss or health issues.

A typical financial plan may have an investment return assumption of 7 per cent annually.  It would be unrealistic for returns to be exactly 7 per cent each year.  On average, over time this is what is used as an estimate.  When investment returns are significantly different – that is a one-year deviation of 20 per cent or more – we recommend updating the financial plan.

When returns are greater than expectations then three things can be discussed.  Consideration should be given to shifting the investment portfolio more conservative as the required returns are now lower.  Another discussion point would be lowering the required amount of periodic savings.  The last item to discuss is the possibility of either retiring younger or having more funds available at retirement.

When returns are lower than expected it is important to assess how this will impact your financial situation.  For some people it may involve saving a little more or working a little longer.  We would prefer these two options rather than encouraging people to take more investment risk.

For younger people, a negative year in the markets has minimal impact to long-term financial plans.  The older a person is, the more the stock market may have an impact on your financial situation.  This is the reason why a person’s investments should shift towards fixed income (bonds, GICs, term deposits) the older one becomes.

The best part about a financial plan is that it provides some clarity relating to savings and long-term goals.  The conclusion after a significant decline or increase in the stock market is a change in the required periodic savings.  The most important component to long-term success is to continue saving during all market conditions.

Safe, secure GICs have downsides

Guaranteed Investment Certificates, or GICs as they are commonly known, are extremely popular savings vehicles.  They are the classic safe investment vehicle that provide a low-risk and low-return combination. Furthermore, many investors prefer GICs as they are a simple guaranteed investment that returns capital plus income.

The Canadian Deposit Insurance Corporation raised this guarantee from $60,000 to $100,000 in the 2005 federal budget.  CDIC provides valuable protection for investors primarily concerned with capital preservation.  When investors place money in eligible deposits they are automatically insured to a maximum basic coverage limit of $100,000, including principal and interest.  For information, visit www.cdic.ca

For all the simplicity and safety of GICs, investors sometimes pay little attention to the risk that their low interest earning investments may not preserve purchasing power over time. Interest rates on GICs are currently at low levels and when one considers the impact of taxes and inflation on their investments, the real rates of returns (return after accounting for inflation) can be negligible or potentially negative.

Let’s look at an example:  William has $300,000 in a non-registered annual pay GIC yielding 4 per cent, and has a marginal tax rate of approximately 43 per cent.  We will assume inflation is at 2.3 per cent.

GIC Income $300,000 x 4 Per Cent = $12,000

Taxes at 43 Per Cent                        =  ($5,160)

Net Return                                       =  $ 6,840

A net return of $6,840 is approximately 2.3 per cent.  With inflation at 2.3 per cent or higher the “real return” will be negative.  Investors with long-term objectives need to understand that the safety of GICs can actually erode the real purchasing power of their investments. In many cases, investors requiring income to provide for their day-to-day expenditures will be forced to encroach on capital as the real returns will be insufficient to meet their needs.

Clients dependent on GICs as their sole investment vehicles need to consider diversifying a component of their investments into alternative types of securities to provide inflation protection, generate tax-effective income, and to build long-term wealth.

Some tips for GIC investors:

Tip 1

We encourage investors to place no more than $100,000 per individual issuer.  Solution:  deal with a firm that is able to issue multiple issuers of GIC’s (as CDIC covers up to $100,000 held per issuing company).

Tip 2

GICs generate interest income which is fully taxed if held in a non-registered account.  Solution:  we encourage investors to look at the structure of their investments and consider putting GICs in their RRSP, as is the normal recommendation for most income generating products.

Tip 3

Occasionally we see GICs purchased near the end of the year in non-registered accounts.  Rather than purchasing a GIC at the end of the year it may make sense to put these funds into a high interest savings account until early January.  This would allow you to defer the annual interest one year.  A $100,000 one year GIC at 4.5 per cent purchased on December 6, 2006 would have $4,500 in taxable income for 2007.  Solution:  waiting until after December 31, 2007 to purchase a GIC would defer this taxable income one full year.

Tip 4

Many financial institutions will ask you if you would like to set up an automatic renewal of your GIC investments.  It only takes a few minutes to discuss rates and reinvestment options with your advisor when investments mature.  During these discussions you may want to consider different options and terms.  Most importantly you should make sure you are receiving a competitive rate.  Solution:  cancel all automatic renewals and ask your advisor to give you a call when your GICs mature.

Tip 5

Many structured products are attaching the “GIC” name in their advertisements.  One of the benefits of a GIC is its simplicity, transparency, and security.   Why does a GIC need to have some type of complicating feature to it?  Do those extra features benefit you or do they provide the issuer with more benefits?  Solution:  speak with your financial advisor for more information and avoid structured products that you do not understand.

Tip 6

Before purchasing a GIC you should determine if it can be transferred or sold.  Some GICs can be transferred to other institutions and some cannot.  In addition, most GICs cannot be sold prior to maturity.  Solution:  speak with your financial advisor for more information and attempt to purchase GICs that are transferable.

 

Fixed-income investments simplified

To diversify your investments you should have a fixed-income component in your portfolio, such as guaranteed investment certificates or bonds.

But you should have an understanding of the different ways of holding fixed income investments and the underlying risk of each option.

Term deposits and guaranteed investment certificates are a common way to hold fixed income.  The return is known and all fees are built into the initial sell price.  If you purchase a one-year $100,000 GIC at 4.5 per cent then you can count on receiving $4,500 and your original capital back in one year.  This certainty comforts a lot of people and the investment is easy to understand.  It is also easy to plan your cash flows.

Holding federal and provincial government bonds are generally considered low risk.  In recent years, GIC returns have often exceeded the returns offered by low risk government bonds.  Investment grade corporate bonds can be another way to purchase fixed income.  The return potential on corporate bonds generally exceeds government bonds and GICs but the risk element increases.

Another common form of fixed income investment is a bond mutual fund or a balanced mutual fund.  A bond mutual fund invests in a basket of fixed income investments.  Depending on the fund prospectus, the mandate can result in significantly different structures between funds.  Not all bond funds are created equal.  Some bond funds are very conservative while others may take on considerable risk.

Conservative bond funds may hold government bonds and investment grade (BBB rating or better) corporate bonds.  Treasury bills, banker’s acceptances, and term deposits are all considered low risk and are common in conservative bond funds.  One of the benefits of holding bond funds is the ability to diversify your fixed income.  Diversification of fixed income can be done through holding different types (issuers), qualities (credit ratings), and maturities (mixture of short, medium, and long term).

The added “diversification” benefit of bond funds comes at a cost often referred to as a management expense ratio (MER).  Regardless of where interest rates are at, it is important to ensure you are not paying an excessive amount to manage your money.

As an example, let’s use a typical bond fund with an MER of 1.5 per cent.  Let’s also assume that GIC rates are currently 4.5 per cent.  Individuals choosing the bond fund option should feel comfortable that the manager can put at least 4.5 per cent in your pocket.  With an MER of 1.5 per cent, the manager of this bond fund will have to take on some risk to earn 6.0 per cent or more. Your return is not guaranteed with bond funds and can be negative.

Riskier bond funds do exist and have very different mandates than the typical conservative bond fund.  Bond funds that hold non-investment grade bonds, also known as high-yield or junk bonds, may certainly have the potential to earn 6.0 per cent or more.  They also have a much higher degree of risk and generally have a higher MER.  Other funds may hold foreign bonds or concentrate in certain countries such as the United States.

We caution investors to understand currency risk before investing in foreign bonds.  For investors with a large portfolio, foreign bonds may provide some additional diversification.  Some bond funds have a small equity component, generally with dividend paying investments such as common shares.  If a fund holds a significant equity component then it is often referred to as a balanced mutual fund (holding a balance of equities and fixed income).

We encourage most investors to keep things simple.  Establish an asset mix and determine the percentage of fixed income that is suitable for your individual risk tolerance. Once the fixed income component is established we recommend most investors stick to lower risk and investment grade options.

Credit ratings help investors determine risk

Not all bonds are created equal.  More importantly, not all bonds are considered low risk.  Terms such as non-investment grade, high yield and junk bonds are often associated with higher risk bonds.

Government of Canada bond yields are the benchmark for bonds in Canada.  The yields are often quoted in the newspaper for the GOC 2, 5, 10 and 30 year maturity bonds.  Yields on GOC bonds are low because of the very high credit quality.  The Government of Canada has never defaulted on any of its debt obligations.  It is these bonds which other bonds such as Provincial issued and Corporate issued are compared.  Many people may be surprised to learn that the only province to ever default on a bond is Alberta.  This occurred in 1936.  However, bondholders did not lose their capital as the federal government provided the capital to pay out the bond holders on behalf of the province.

Rating agencies were created to help clients measure relative safety of different companies issuing bonds.  Three major rating agencies are Standard & Poors (S&P), Moodys and Dominion Bond Rating Services (DBRS).  These companies provide credit ratings on bonds (and certain other types of investments).

As an example, DBRS provides independent credit analysis on government debt, short-term corporate debt, preferred shares and long term corporate debt. DBRS assigns a letter grade that indicates the credit risk of the bond issue.

From DBRS, the following are the letter grades, credit rating and explanations:

  • AAA Highest Credit Quality: Highest credit protection, excellent financial health, very profitable future outlook, strong and stable industry and earnings (it is rare to achieve a AAA rating).
  • AA Superior Credit Quality: Very high credit protection, profitable future outlook, good financial health, strong and stable industry and earnings. Marginally below AAA.
  • A Satisfactory Credit Quality:  Good credit protection, medium to large company, fair to good financial health. Slightly cyclical.
  • BBB Adequate Credit Quality:  Adequate protection, fair future prospects, adequate financial health, more economically susceptible.
  • BB Speculative Credit Quality:  Uncertain protection, quite susceptible to changes in economic conditions, smaller size, less liquid.
  • B Highly Speculative Quality:  Highly uncertain protection, volatile earnings and highly susceptible to economic fluctuations.
  • CCC Very Highly Speculative:  Little or inadequate coverage, in danger of           Quality         default if situation not remedied.
  • CC Extremely Speculative:  Even higher danger of default than CCC rated quality bonds if situation not remedied.
  • C In Danger of Default:  In immediate danger of default. Lowest possible rating without actually being in default.
  • D Default:  Currently in default of principal and/or interest.

The above is one example of a company’s rating system.  The rating agencies each have a slightly different system.  Most use a three tiered nomenclature within each letter grade such as “low”, “mid”, or “high” to differentiate even further.   For example, an A High (AH) would indicate the highest rating within the single A grade, which would be one notch below a AA Low (AAL).

Rating changes for a corporation can have a significant impact.  Potential downgrades result in future financing efforts becoming more costly and difficult.  Pension plans, and certain managers may have guidelines as to the quality of fixed income investments they are permitted to hold.  The BBB rating and above is considered “investment grade.”  A downgrade beneath this level may result in some investors forced to sell these bonds.

Bonds with lower credit ratings are considered riskier investments and have a higher probability of default.

However, as an investor considering a lower credit quality bond you should be expecting a higher potential rate of return.  Investors must always balance the risk of default prior to maturity.

We encourage our clients to invest in fixed income that is considered investment grade (BBB) or better.   Here’s our three rules for minimizing risk when investing in fixed-income securities:

  • Focus on investment grade fixed income
  • Avoid structured products that can be costly and thinly traded
  • Diversify by purchasing different types, issuers and maturity dates.

Fixed Income 101: Carefully plan debt investments

Fixed income is an asset class that includes short term money market instruments, term deposits, GICs, government bonds, corporate bonds, debentures, and bond funds.  All of these investments are considered “debt” investments rather than “equity” investments.

When buying debt investments an investor is essentially lending money to the issuer of the bond.  For example, a company that needs to raise money generally has two ways to do so – issue stock in the open market or borrow.  By issuing a bond, the company is promising to repay money at maturity, along with, interest.

When purchasing fixed-income investments there are several things you should consider:  credit quality, liquidity, yield-to-maturity, term-to-maturity, and expected income stream of the investments.  The following five questions provide a framework to assist you in evaluating the relative merits of a particular investment.

1. What will my return be?

In order to determine how much you will earn on your fixed income investment, you generally need to consider two things: the coupon of the bond, and the overall yield.     The coupon is the percentage of the bond’s face value that you will receive as income on a periodic basis.  Most bonds pay coupons twice a year.  Yield (called yield to maturity for bonds) is often the more important number to review as it allows bonds of different coupons and maturities to be compared to each other.  Yield to maturity is the total return, made up of interest and repayment of principal that you will receive if you hold the bond to maturity.

2. When will I get my money back?

Most fixed-income investments are issued for a specific period, such as five years, and have a set maturity date.  This is the date on which the face value or principal amount of your investment will be repaid by the issuer, or borrower.

3. How safe is my investment?

You should always check what type of security or guarantee is behind your investment.  Most bonds are not backed by specific assets, but are backed by the full faith of the issuing company.  An investment is considered to be extremely safe and have high credit quality when there is little likelihood that the issuing government or corporation will default on interest payments or not repay your principal.  Bond rating agencies provide investors with information to assist them in gauging the credit quality of their investments.  Lower quality companies will have a higher likelihood of not paying out and therefore be rated lower.  Lower quality bonds will offer a higher yield to attract investors.  Remember higher risk, usually means higher return.  Higher quality bonds, with little chance of default such as Government of Canada, have a lower yield.  You should choose a balance of risk and return that meets your tolerance level.

4. Why is the price changing on my bonds?

Before investing in bonds, you should be aware of any potential volatility that could affect the value.  GICs are an example of a type of fixed income investment that do not fluctuate in value.  However, regular bond prices are affected by moves in interest rates, and therefore prevailing yield in the marketplace.  Bonds prices move inversely to the prevailing interest rates.  As rates go up, bond prices come down and vice versa.  Generally, if a bond has a coupon that is larger than the prevailing yield in the market, the bond will trade above 100.00, considered a premium.  Conversely if the coupon the bond is lower than the prevailing yield in the market, the bond will trade below 100.00, considered a discount.

Bond prices are more likely to remain stable when they are high quality, more liquid and have a shorter term-to-maturity.  Changes in the price of bonds can present different opportunities for active investors.  However, if you plan to hold a bond investment until its maturity, you will receive its face value, therefore, market volatility will not be a factor (provided no default).

5. Can I sell my fixed income easily?

Although you may intend to hold a fixed income investment until maturity, you should still obtain an understanding of its liquidity.  Circumstances may change and you may require cash.  Some fixed income investments are extremely liquid which means that you can sell them easily before they mature.

If you sell a bond between periods of receiving coupon interest you will receive from the purchaser the accrued interest you have earned up to that date.  Less liquid bonds may be harder to sell in the secondary market.  GICs are different than bonds when it comes to selling.  Cashable GICs should not be redeemed within 30 days.

Early redemptions generally result in a loss of interest.   Cashable GICs are usually classified as cash equivalents rather than “fixed income” because of their liquidity and short duration (one year or less).  As for non cashable GICs, investors may be able to find a market to sell.  It is not advisable to buy GICs if you know you may need the money

Balanced investments show success

One of the first discussions we have with new clients relates to risk, which is often associated with equity investing.

Fixed income investments such as term deposits, guaranteed investment certificates and bonds are usually considered lower risk.

Most investors over the age of 40 should have a portion of their investments in fixed income as their time horizon is shorter.  However, the downside to having too much fixed income is the limited return potential in today’s market environment.  Cash and fixed income ensure capital preservation while the equity component provides increased growth potential.

The key to having “peace of mind” as an investor, is to have the appropriate balance that reflects your risk tolerance.  This balance is also known as your asset allocation.

Asset allocation classes include cash equivalents, fixed income, Canadian equities, US equities, International equities and real estate.  Let’s look at Jack Jones and the steps taken prior to choosing individuals investments.

Step 1 involves determining an asset allocation that best matches Jack’s risk and return expectations.  Here’s an example of his optimal asset allocation:

Cash Equivalents 5%

Fixed Income 30%

Equities – CDN 35%

Equities – US  10%

Equities – International 15%

Real Estate 5%

A person who is more conservative than Jack may want to increase the cash equivalents and fixed income component while decreasing equities.  What we find is that many do-it-yourself investors take an all or none approach to a specific asset class.  This means they may end up with either a 100 per cent equity portfolio or all of their money in GICs.   Portfolios that are 100 per cent invested in equities generally are more volatile, and hold greater risk of decline.  However, those who invest entirely in GICs may find it frustrating as yields are generally much lower.  In addition, for non-registered accounts interest income is fully taxable.  After tax is paid, it may be difficult for GIC investors to gain wealth after inflation is factored in.

Simply put, most investors should have a balanced portfolio that can weather different market cycles.

After the optimal percentages are determined above, Step 2 is to establish acceptable ranges as follows:

Cash Equivalents 0-10%

Fixed Income  25-35%

Equities – CDN 30-40%

Equities – US 5-15%

Equities – International 10-20%

Real Estate 0-10%

In a bull market cycle investors may find that the equity component of their investments may increase above the optimal amount noted above.  If the value of the equity class exceeds the acceptable range then a disciplined investment approach should involve rebalancing to the optimal percentages in Step 1.

This rebalancing is Step 3.  Selling equities and adding to fixed income and cash equivalents essentially shifts a portion of your profits to a lower risk asset class.

We encourage investors to stick to their long-term plan.  As fixed income securities mature, we should replace those investments with other fixed income options.

What happens in a bear market cycle?  Investors may find that the fixed income component as a percentage of their total investments increases as equity markets decline.  As noted above a disciplined approach to investing involves rebalancing.  It is possible that this process may involve allocating some of the proceeds from matured fixed income to purchasing equities.  This would only occur if equity markets have declined significantly.

Periodic rebalancing creates the discipline to sell a portion of your equity investments when times are good.  The cash equivalents and fixed income components should also be viewed as a potential source to purchase equity investments when the opportunity arises.

RRSP income splitting strategies

The primary objective of income splitting is to reduce your tax liability as a couple and as a family.   Pensioners are now able to split qualified pension income, but before you take information to your accountant you may want to check that you are considering all strategies available and that your income will qualify.

Know the Rules

People should know that Registered Retirement Savings Plan withdrawals are not eligible to be split with your spouse.  One way for people aged 65 or older to make this income eligible for pension splitting is to convert all or a portion of their RRSP to a RRIF, which is eligible for pension splitting.

Assuming that you have eligible pension income to split, you should also be looking at how this affects both tax situations.  You should be aware of what will end up happening from a tax standpoint with this shift of income from the higher income spouse to the lower income spouse.  A spouse that normally may not have had much income suddenly will have income.

Does this create a planning opportunity?  At the same time that pensioners are allowed to income split they have increased the age for mandatory RRSP conversions to a RRIF.  Pensioners that income split may have unique strategies that didn’t exist last year.  In many cases, one member of the household may have income eligible to be split of $60,000 and a spouse that has little to no income.

For those people who feel like deferring tax a little further may want to consider an RRSP contribution by the lower income spouse.  This strategy will involve you speaking with your accountant before February 29 and may be suitable in the case where the lower income spouse has not been able to utilize RRSP deduction limit.

Here’s an illustration to make the point:

John and Karen Garmin were married 37 years ago and both are 61 years old.  At the end of last year, John took early retirement.  He has worked in a consulting capacity part time over the last year.  John has received approximately $60,000 in pension income and $25,000 in other investment income and employment activities.

John has elected to transfer $30,000 of his eligible pension income to Karen.  This reduces John’s taxable income to $55,000. Karen works part time and has annual employment income of approximately $15,000.  With the transfer of pension income, Karen’s total income is expected to be $45,000 for 2007.  Over the last 37 years Karen has worked part time and raised three children.  Working part time she has slowly accumulated a nice size RRSP contribution room.

Prior to the pension income splitting rules it never made sense for Karen to contribute to an RRSP based on her previous income of $15,000.  Karen brought us her 2006 Notice of Assessment and we noticed $29,200 in RRSP room.

We discussed with Karen that she is now in a better position to contribute to her RRSP.  She also mentioned that she planned to work for four more years.  The $15,000 that Karen earns annually is accumulating $2,700 new room each year.  Both John and Karen have significant savings in the bank.  We recommended that Karen plan to contribute $10,000 annually for the next four years to defer tax further.

Other strategies involve a little more planning and will result in splitting income in the future.  A good example of one strategy for younger couples is a spousal RRSP.  In the past, this was one of the best income splitting strategies available for couples.  The spouse with the higher income can make a spousal RRSP contribution to a plan in the name of the lower income spouse.  The higher income spouse receives the deduction however the funds accumulate for the benefit of the lower-income spouse.

We still like spousal RRSPs, even after the pension splitting announcement.  Some people may feel that spousal RRSPs will no longer be applicable now that pension splitting is allowed.  Unless you can predict your future we would disagree.

There may be an opportunity for you to retire at a younger age than expected.  Possibly you will need some funds from your RRSP for emergency purposes before the age of 65.  Certainly we cannot predict what the government will do in the future.

These are just a few reasons why a spousal RRSP may still make sense.  One component to a spousal RRSP that you should be aware of are the attribution rules.  The attribution rules apply if withdrawals are made from the spousal RRSP in the year of the contribution and the following two years.

Here’s another illustration:

Mary works as a lawyer and earns approximately $90,000 a year.  Her husband Bill is currently earning approximately $20,000 a year working part time and also attending university.  Mary already has accumulated significant savings both registered and non-registered.   Mary also anticipates that she may receive a large inheritance in the next 10 years.  Based on their situation we recommended that Mary contribute to a spousal RRSP for Bill.  Mary would still receive the tax deduction and Bill would begin accumulating savings for retirement.