Because, hey, who should be a better credit risk than yourself? (Immediately defaults)
Here at the ol’ FU machine, we’re all about giving you kids some of the most unusual investing ideas out there. I’ve outlined everything from putting your cash to work lending dirtbags money to buying a storage locker business. And that’s just in the last month. I’ve come up with more odd investment ideas in the past six months than most people do in their lifetimes.
There’s a reason why I do this. Most investment bloggers (and, hell, personal finance bloggers too) do nothing but chronicle their very predictable actions. There’s very little to gain by retracing the beaten path. The real opportunities are in the bushes where nobody is looking. Probably because there are snakes. Or spiders.
At first glance, you may not realize the benefits of something like giving yourself a loan. Why would such a thing be beneficial? You’re literally just taking money from one pocket, charging yourself interest, and then putting less of it back in the other pocket. It seems like action for the sake of action.
But there are actually two very interesting reasons why you’d want to give yourself a loan. Let’s look at each of them.
Starting a company
Every company needs a certain amount of start-up capital.
Most people fund their companies in a very predictable way. They use their own savings as initial capital.
Say you bought a fast food joint for $200,000 and immediately incorporate the thing as its own business. You decide to put in $50,000 of your own money into the company as shareholders equity and lend the corporation the other $150,000.
Most people lend their corporation money interest free because they want the business to succeed. The business then pays back the loan as it can afford it.
But there’s no rule that indicates this loan has to be interest free. In fact you can, in theory, charge yourself all sorts of interest. As long as it’s considered to be the going rate, you’re good to go.
What most people do is research a little and see the rate a bank would charge them to do the same loan. If a bank would charge 6% in a similar situation, you could easily charge your corporation the same amount.
Remember that you’ll have to make this a legit loan. Paperwork will need to be done and the corporation would have to make the designated payments. You can’t just give yourself a loan and have the terms be “I’ll pay back whatever whenever I want.” Do you really want to make your accountant cry?
Give yourself a mortgage
This one is a little more complicated, but it can be lucrative for a very small percentage of the population. It turns out it’s possible to hold your mortgage in your RRSP.
It works something like this. There are all sorts of different investments you can put in your RRSP. It’s not just stocks, bonds, or ETFs, either. It turns out you can totally invest in certain qualified mortgages inside of your RRSP. This is how those private mortgage companies can get away with saying they’re RRSP eligible.
Even though I’m in the private mortgage business I’ve never examined the possibility of holding them inside my RRSP. As far as I can tell they need to be first mortgages only, and they need to be insured by one of the various agencies that do this.
It’s less complicated to hold your own mortgage inside your RRSP, although it’s certainly not easy. Here’s how it works.
- You pay someone to set up the deal for you. Only certain financial institutions will do so and you’ll have to pay CMHC insurance fees.
- You have to make sure that you have enough contribution room to pay for the whole house, not just the part mortgaged.
- The interest rate you give yourself must be competitive with comparable mortgages. I’m thinking you’d pretty much be locked into giving yourself a loan at 4.64% which is sure better than a GIC but could easily be beaten by stocks.
I’ve pretty much only touched on the basics. There are a number of companies that will do this for you. Do some Googling and talk to one of them before you get started. I’m not getting too involved in this because, frankly, I think it’s kind of dumb.
This is the end
It’s not that hard to give yourself a loan if you’ve got a corporation. There are a number of advantages for self-employed people to incorporate, as I outlined in this post. Getting a little interest from your own corporation is another, but you could argue that doing so is just shuffling money from one pocket to the other.
Ultimately, I won’t spend much time doing this, but it could very well make sense in certain situations. Your accountant can probably help out with this more than I can.
Many people are dividend growth investors for one big reason. They want those dividends to fund their retirement. And because all the cooooooool kids are doing it.
There are a number of reasons why this makes a ton of sense. People like the idea of spending the dividends while the capital base stays intact. One stock can always cut its dividend, but a portfolio of 30 or 50 names is pretty secure. And there are many tax advantages to limiting retirement income to dividends.
But there are also disadvantages to such a strategy. Having a portfolio of 100% stocks during retirement is risky as all hell. Most of North America’s premier dividend growers are pretty overvalued today too, suggesting they won’t do as well in the next 30 years as they did in the previous 30. And with rates so low, dividend yields kinda suck.
Instead, let me talk about a better solution.
Enter the preferred share
Preferred shares are kind of like Donny and Marie Osmond. They’re a little bit stock and a little bit bond.
Here’s how they work. A company needs cash, so they issue a preferred share. This share pays dividends, but tends to act more like debt than equity. As long as the market is convinced the underlying company can afford the dividend, they’re fine.
Preferred shares are between equity and debt on the corporate hierarchy. So if the company does run into trouble and suspends the dividend on its common shares, the preferred shareholder still gets paid. And if preferred share dividends get suspended, the company is basically bankrupt.
There are two types of preferred shares. There are perpetual preferreds, which don’t really have an expiry date. The company has the right to redeem them on a certain date at a certain price–usually par, which is $25 per share most of the time–but not the obligation to do so. There are preferred shares still floating about that have been around for 20 years. Or more. They’re like your kid who won’t leave your damn basement until they hit 35.
The other kind of preferred share is the rate reset version, which pays a fixed interest rate for five years. It then resets to a new rate, which is usually based on the Government of Canada five-year bond rate. The new rate might be the bond rate plus 2% or 3% or whatever. It depends on the credit worthiness of the company issuing the preferred in the first place.
There are many more complex details about preferred shares that we don’t need to get into right now. The point is this. If you’re looking to build an income stream using these things, you’ll want to stick with the perpetual ones.
Now the income part
Here are a few examples of perpetual preferred shares along with their yields.
- George Weston (TSX:WN.PR.E) — 5.3%
- Power Corporation (TSX:POW.PR.A) — 5.6%
- Power Financial (TSX:PWF.PR.E) — 5.5%
- Bombardier (TSX:BBD.PR.C) — 9.8%
- Bank of Nova Scotia (TSX:BNS.PR.O) — 5.5%
- Canadian Utilities (TSX:CU.PR.D) — 5.4%
- E-L Financial (TSX:ELF.PR.F) — 5.5%
- Enbridge (TSX:ENB.PR.A) — 5.5%
- Investors Group (TSX:IGM.PR.B) — 5.9%
And so on. There are a million of these things. There are even more if you want to get a little frisky and include the floating rate ones.
With the exception of Bombardier, you’ve probably seen a pattern emerge. Most preferred shares in Canada yield between 5.5% and 6%, with most on the bottom end of the spectrum. They’re also much more boring. Take a look at the difference between George Weston common shares and the preferred shares.
You might look at this chart and wonder why you’d ever own the preferred shares. Look how well the common shares did!
But the preferred shares are a whole different ball game. They’re supposed to not do much. They’re designed to protect principal, not go up.
Or buy an ETF
There are two preferred share ETFs in Canada and a few more in the U.S. The big one in Canada is the Claymore Preferred Share ETF (TSX:CPD) which has a combination of perpetual preferreds and rate-reset preferreds in it. It yields 5% on the nose.
BMO offers a laddered preferred share ETF (TSX:ZPR), which aims to limit the risk of the rate reset preferreds resetting. It has equal numbers of shares that reset in year one, year two, etc. It yields 5.05%.
What about interest rate risk?
There are two things that will cause a preferred share to crater. Either the underlying company goes all to crap or interest rates start rising.
That’s the big risk in a preferred share strategy. When rates increase, investors can get higher yields from new products. So existing preferred shares go down to compensate, boosting the yield higher.
Perpetual preferred shares are the most exposed of all to such a move. Rate-reset preferreds have interest rate protection built in. Perpetuals don’t.
There are two ways to protect yourself from interest rate risk.
The first is to commit to holding any preferred shares over the long-term no matter what the underlying price does. Remember, it’s only a loss if you sell.
You can also help protect yourself by reinvesting some of your dividends back into higher yielding shares. It’ll pale in comparison to the original investment, but at least it’s something.
Preferred shares are a way for retirees to get a nice income while taking advantage of the dividend tax credit. They’re also much less volatile than regular ol’ common shares.
They’re also a decent way for younger investors to get income too. Preferred shares will never be as safe as a GIC, but they’re boring enough that I’d consider them a very decent fixed income alternative. I own a bunch of them that very quietly churn out some very predictable cash flows. You should too.
Disclosure: Nelson owns George Weston, EL Financial, and Enbridge preferred shares.
If you believe the personal finance blog-o-net, the side hustle is the greatest thing since sliced bread. Do you know how people ate bread before they sliced it? IN CHUNKS LIKE A BUNCH OF G.D. CANNIBALS.
This seems like a good time to segue into some posts I wrote about side hustles, including 10 you can totally do and some overrated ones that you should avoid. The ones you should avoid is actually funny! Really! What, you don’t believe exclamation points!?
I’m generally in favor of the side hustle. Most people squander their leisure time anyway, and fun hobbies are expensive. Have you gone golfing lately? They literally tip you upside down and collect all the money that falls out.
But at the same time, I think people need to be smarter about what they decide to do on the side.
An overrated side hustle
I have two friends who ref sports on evenings and weekends.
One makes less than $20 per hour at his day job, the other makes at least $30 per hour and likely close to $40 per hour, depending on how many hours he works. He definitely works more than the first guy, anyway.
And yet both are driving around the country on weekends, reffing sports for $20 to $25 per hour.
The first guy should be reffing all day long. If he’s willing to exchange his time at $17 per hour at work, then $25 per hour reffing is great. Hell, reffing should almost get priority.
But how about the other guy? What’s the thought process there?
The answer is pretty simple. He likes to get yelled at by teenagers and overzealous coaches, for some reason. He’s a sports nut, and getting paid to watch sports is a good time for him. Excluding all the yelling, anyway.
And so that’s fine. There’s nothing wrong with doing something you enjoy and getting paid for it, provided you don’t piss off the $40 per hour boss.
If we look at it from a purely economic perspective though, a different picture starts to emerge. Instead of exchanging his time for $20 or $25 per hour, he should really be looking for ways to make more money at his day job. Evening and weekend hours are precious. They should be exchanged for more money, not less.
One of the reasons why we love side hustles is because they allow us to diversify our income. I’m a big fan of multiple revenue streams. That’s why I invest every spare nickel I can into cash-producing investments. I heart me some cash flow baby.
But just because diversity is important it doesn’t mean it’s the only thing.
Damn near every job has the potential to take on additional work for extra money. Overtime is very much a thing. And even if your job doesn’t offer it, there are still ways to leverage your professional knowledge into getting paid the most for a side hustle.
Overtime at work is paid at a higher rate than your normal wage. Employers get that extra hours should be paid more. Why shouldn’t regular folks demand the same for their side hustle?
Having another income source is great on the off chance you get fired from your job. But it’s super easy to create your own passive income stream by making bank working overtime at your day job and investing the proceeds.
Let’s wrap it up
Ultimately, it comes down to this. Your time has value. If it didn’t, you’d exchange it for 2-for-1 coupons at the Golden Corral. Actually, I’ve done that before. Bad example.
I realize there are often non-economic reasons for people doing what they do. Side hustles fall into that category more often than not. They’re fun, in other words. I know I felt that way about writing stuff.
But that doesn’t give people a pass on analyzing the economic viability of their favorite side hustle. Often, the best way to exchange your time for more money is by taking overtime at work or leveraging your professional skills. It’s not in doing something completely different. Remember that before taking that evenings and weekends job.
Should I start with a junk in the trunk reference, or point out that the term junk is also a slang word for male genitalia? Decisions, decisions.
As I’ve explained before, y’all gotta get yourself some bonds. They serve a couple of purposes. First, they tend to go up when CRAZY TWEETING PSYCHOPATHS LIKE DONALD TRUMP make stocks crash. SMDH, he’s already ruining America.
Wait. I’m being told that didn’t happen. Well. That’s surprising.
When stocks crash, that’s usually a good buying opportunity. Since most people are fully invested (or at least should be, since opportunity costs are a very real thing), they don’t have a ready cash source available when it’s time to start buying. That’s where bonds come in. You sell them and buy equities.
There’s just one problem with bonds today. They don’t offer much in yield. Canada’s biggest bond ETF (the iShares bond universe index fund, ticker TSX:XBB) pays less than 3% annually. That’s not bad when compared to a GIC, but it’s not very exciting. I NEED A RUSH BABY YOU GUYS GOT ANY METH?
There are other bond sources that pay much higher yields. Let’s take a closer look at junk bonds, the perfect thing to sexy up your fixed income portfolio.
What are junk bonds?
Junk bonds sound bad, Nelson. Real bad. I don’t care for things that are bad.
Thanks for helping out, Italics Man.
Junk bonds (or high-yield bonds if you’re being paid by someone who peddles such things) are debt instruments issued by riskier companies. The bond risk hierarchy goes something like this:
- Mortgages and other things backed by the government
- Provincial/State governments
- High-quality corporate debt
- Medium-quality corporate debt
- Countries ran by dictators or Greece
- Terrible corporations
- Your friend Steve
When interest rates were higher, the spreads between the best risks and the worst risks was in the neighborhood of 5-20%. That spread has tightened somewhat. A government can get short-term money for 1%. Most junk bonds don’t pay any higher than 8%.
Junk bonds don’t really behave like regular bonds. Most bonds go up and down based on two factors — interest rates and the direction of stocks. Often these two things go hand in hand. So if stocks fall, that means rates will fall with them. Bonds will then go up. The opposite happens when stocks rise. Junk bonds do follow interest rates, but they also react alongside stocks. They’re much more sensitive to the overall health of the underlying company.
Look at it this way. Microsoft is one of the safest bets in the corporate bond world. It’s going to pay back its debt no matter what. Things are much dicier for a company like Teck Resources. It needs a halfways decent economy.
How to invest in junk bonds?
Let’s focus with the two easy ways, which are through ETFs or closed-end funds. You can also buy individual junk bonds, but if you could do that you’d probably be reading smarter stuff than this crap.
There are a metric assload of junk bond ETFs out there, all with their own unique spin on the world but with only the smallest of differences. Hey, just like personal finance blogs!
Oh, that’s gonna get him punched.
The biggest junk bond ETF is the SPDR Barclays Capital High Yield Bond ETF, which has a very appropriate ticker of JNK on the New York Stock Exchange. It holds 811 different bonds that have an average yield to maturity of around four years. It pays out a dividend of 6.1%.
The junk bond world in Canada is much smaller than in the U.S., so we’re pretty much stuck investing there. But there are quasi-Canadian ETFs that at least trade on the Toronto Stock Exchange. BMO has a U.S. junk bond ETF that’s hedged to Canadian Dollars (TSX:ZHY), that pays 6.1% and has an average of about four years maturity left. But it only holds 463 different bonds like a chump and/or chumpette.
I don’t own any of these ETFs. Instead, I use a closed-end fund to get exposure to the sector. I even pay a management fee of (gasp!!!) greater than 1% to do so.
I own the Dreyfus High Yield Strategies Fund (NYSE:DHF) which uses leverage to enhance junk bond returns. In a nutshell it takes a dollar, borrows an additional thirty cents, and invests the $1.30 in a couple hundred junk bonds. Because it can borrow at good rates, this gooses my yield in exchange for a little more volatility. I’m quite okay with this trade-off.
My Dreyfus closed-end fund yields 9.8% versus 6.1%, which is what a comparable ETF pays. If we’re looking for income, that’s good.
I’ve held that fund for close to a decade now. It has cut the payout a few times, but only because bond rates went down. Individually, junk bonds are risky. A group of two hundred of them aren’t. The risk is in interest rates, not so much with companies not paying.
If you’re interested in the whole leveraged bond market, there are dozens of such closed-end funds out there. I should really do a blog post on some of them.
Should you do it?
Yes, you should add junk bonds to your portfolio. They’re volatile, but they are also a pretty outstanding income source.
In the decade I’ve owned the asset class, I’ve basically broke even on the price of my fund and collected a dividend of approximately 10%. I’d call that a decent result.
There are just a couple of things to remember. First, consider them equities rather than bonds. They won’t be an ocean of tranquility when markets are falling. And don’t freak out about price movements. I’ve always considered the asset class a cash flow game. It’s the perfect investment to tuck away and forget about for a while, especially if you own it in a fund.
We all like the dividends, right?
OMG NELSON YOU HAVE NO IDEA I LITERALLY LOVE TO HUMP DIVIDENDS OH BABY.
That reaction is a little over the top, but hey. It’s probably pretty accurate.
I’ve came out before in my opposition of dividends. I used to think people who insisted on every stock they own paying a dividend were uninformed and setting themselves up to accept lower returns going forward. After all, dividend-paying stocks sure have been helped by a 30-year decline in interest rates. Thousands of retirees have abandoned GICs and government bonds, searching for the yield they need to survive in this pension less world.
But I’ve softened my stance over the last little while. It’s actually gotten to the point where I prefer to invest in companies that pay a dividend. I like getting paid to wait for whatever stupid little value stock I own to recover. I then reallocate that capital into other investments, creating my own compounding machine in the process.
Thanks to low interest rates and our terrible savings rates, stocks that yield between 5-10% are more popular than eating bacon while watching some show about zombies. Isn’t that what you kids do? I dunno.
But there’s a problem with these kinds of companies. Big yields tend to equal big risks. Sure, you can analyze the financials to see whether the company can afford the payout, but that’s hardly a foolproof method. Earnings aren’t guaranteed, neither are dividends. Management can and will cut payouts.
So you have a problem. You need a lot of yield from a portfolio, but you don’t want to take huge risks to get it done. What’s an investor to do besides wet themselves with fear?
Well, there are several strategies. Let’s look closer at using covered calls to get enough income to finally get the ladies at the retirement home to notice you.
What are covered calls?
Great question, guy who just asked that. Give yourself a raise.
Before you read this, go ahead and verse yourself on the basics of option market. Or not. Whatever, it’s a free country.
Covered calls work a little something like this. A call option gives you the right to buy a certain stock at a certain price on a certain day. If you straight up buy calls, you’re essentially making a bet that the underlying stock goes up in value.
You can also sell a call, which means you collect the premium up front in exchange for locking in a certain selling point of the underlying security. This is a dangerous thing to do unless you own said security.
If you do own the security, you’re writing what’s called a covered call. I promise, this will make more sense once I show you a specific example.
Okay, say you owned 100 shares of Telus, a stock currently trading for $40.25. The $42, May 20th call option currently trades hands at $0.22 per share. What you’d do is you’d enter into a transaction to sell the call option, collecting $22 today in exchange for agreeing to sell your Telus shares at $4,200 on May 20th.
Still with me? Good. Okay, one of two things can happen. Telus shares can end the next month at less than $42 or more than $42.
If Telus shares end up below $42, this is a good trade to make. You’ll collect your $0.22 per share premium with no consequences. FREE MONEY BABY. If you repeat that trade over and over again each month or each quarter (some shares have monthly options, but most don’t), it’s easy to see how you can really goose your dividends. Add the call premiums to Telus’s already generous dividend and you get a total yield of approximately 10%.
The issue with a covered call strategy is when shares go up. If Telus closes at $42.01 on May 20th, you’re forced to sell your shares for $42. This isn’t so bad on the surface, since you’ve still made a gain of $1.75 per share plus the $0.22 per share option premium you collected at the beginning. Not a bad profit for a month, right?
But what happens if me and all my rich friends decide we’re going to acquire Telus at $50 per share? This offer would send shares soaring, leaving you kicking yourself for agreeing to sell at $42. You’d be missing out on a lot of excess return.
This is precisely why a covered call strategy is more popular for big, mature, boring blue chip stocks like Telus. Shares of such companies don’t tend to move that much.
That’s covered calls in a nutshell. Essentially you’re exchanging income now for potential capital appreciation in the future.
The easier strategy
Those last paragraphs were kinda complicated, right? I bet you didn’t even read them. You did? LIAR. DON’T LIE TO ME I CAN SMELL LIES.
So instead of doing the hours of work it would take to implement your own covered calls strategy, just take the lazy way out. Pay some guy to do it for you.
There are plenty of options. The first is a closed end fund ran by former Dragon’s Den star Brett Wilson’s company, Canoe Financial, called the Canoe EIT Income Fund (TSX:EIT.UN). Shares of this closed end fund trade at $10.49 each and it pays a monthly dividend of $0.10 per month. That’s good enough for a yield of 11.4%.
There’s one simple reason why I like this fund, and it’s not because of the management fee, which is north of 1%. It’s because the net asset value of it is currently $12.32 per share, meaning you’re buying shares of really easy to value companies at a discount of about 20%. Each year, the fund gives unit holders the right to redeem shares at 95% of NAV. The offer is always oversubscribed, but on average, about 20% of units tendered get redeemed. It’s a nice capital gains perk for a product that’s just supposed to be about the income.
BMO has at least two covered call ETFs, the Canadian banks covered call ETF (TSX:ZWB) and the covered call utilities ETF (TSX:ZWU). The utilities ETF yields close to 7%, while the bank ETF is closer to a 5.5% yield, something that’s not very interesting considering the banks themselves yield about 4%. Both beat the Canoe product in management fees (coming in at 0.65%), but lose big time in yield. Since these are income-first products, yield matters. A lot.
All of these products have cut their income over the last five years as more and more people use the options market in an attempt to generate income. So don’t go thinking that a covered call strategy is something you can count on. It has the same sorts of risks inherent with other forms of investing.