For Canada, the economic news these days couldn’t be better. Commodity prices are soaring, so farmers in most regions are making a profit. But costs are rising, too. Oil prices are up dramatically, so drillers, upstream producers, integrated oils, oil well supply companies, etc. are happy. We’re shipping more coal and copper to China, more oil and gas to the U.S. as it recovers, and the troubles of Libya, Yemen, Tunisia, Egypt and Bahrain are all working in Canada’s favour.
This heap of troubles has translated into gains in the S&P/TSX Composite index, which is up 18 per cent in the 12 months ended Feb. 28, 2011 and in the bond market, which is worrying less about insolvency risk in Canadian corporate bonds. Corporate balance sheets are stronger with interest rates low and income rising. Government bond investors have relatively little inflation risk to worry about. After all, with the Canadian dollar rising, the cost of imported food is falling, perhaps enough to compensate for a little inflation.
For Canadian investors, the strong loonie and rising energy and commodity prices are actually a mixed blessing. The stock market is pricey. Canada’s bond market offers only modest returns in risk-free government bonds. Government of Canada two year bonds pay 1.84 per cent compounded annually for two years and 2.65 per year compounded annually for five years. In a taxable account vulnerable to both inflation and income tax, those are virtually zero returns. If you don’t take on some time risk in long bonds or default risk in corporate bonds, there is virtually no money to be made.
Canadian corporate bonds, however, still offer some good deals if you are willing to take a little default risk and some time risk. Issues 10 years and over from Consumers Gas, Hydro One, Fairfax Financial and Great-West Lifeco offer yields to maturity of five per cent or more per year compounded annually. Several exchange traded bond funds that hold Canadian corporate bonds enable investors to skip the arduous research needed
to assess default risk. For example, the BMO Mid Corporate Bond ETF has a relatively low 32 basis point MER and is in a sector that has returned four per cent to six per cent per year for the last few years. Other ETF vendors such Claymore Investments and iShares have potentially attractive bond fund offerings. Bond ETFs tend not to trade their portfolios very much and therefore tend to be more tax efficient than actively managed bond funds that are vigorously traded.
Outside of Canada there are good buys in emerging markets bond funds, for in the new world of risk aversion, a lot of investors are running away from perfectly sound bonds from Turkey and Malaysia. In a time in which geopolitical doubt is in fashion, pension funds and insurance companies don’t want to be caught with a wad of Thai bonds, no matter that there is absolutely nothing wrong with them. This could be an entry point for investors who are willing to wait out a reversal of the market. Or for investors who don’t want to be contrarians and bet that big institutional investors are wrong, the time could be ripe for getting on the commodity bandwagon and rising the rising crest of coal, copper, bacon and lumber prices.
Commodity investments are a natural in the present market. After
all, it is food and energy that are pushing up Canada’s Consumer Price Index. Buying into a commodity fund is a natural way to play the trend and, indeed, to hedge the erosion of financial assets by inflation. Global commodity futures indexes are up 30 per cent in the period Sept. 1, 2010 to March 1, 2011. For a good analysis of commodity price trends, see Scotia Capital’s Commodity Price Index Report at http://www.scotiacapital.com/English/bns_econ/bnscomod.pdf.
One of the more senior funds in the commodities sector, the Criterion Diversified Commodities Fund, was up almost 27 per cent in the 12-months ended January 31, 2011. That’s great recent performance, but the record for the four years ended January 31 is a dismal 0.72 per cent per year compounded annually. A GIC would have done better. The point: commodities are among the most volatile of investments. Making any off-farm investments in the sector should be done modestly and through a fund that diversifies risk among many commodities.
For an extensive list of commodity ETFs, see http://etf. stock-encyclopedia.com/category/commodity- etfs. html. It includes, for example, gold, platinum, copper, carbon, cotton, gas, palladium and soybean specialty funds and leveraged funds that allow investors to get extra play out of long or short positions. Note that funds sold on American exchanges are priced in US dollars and therefore add exchange exposure to underlying asset price moves.
A new commodity fund, the Claymore Broad Commodity ETF, has only a record of a few months to January 31, 2011 during which it gained 12.75 per cent to 12.96 per cent, depending on which version you buy. Other ETFs worth a look include the Claymore Global Agriculture ETF, symbol COW, and the Market Vector Agribusiness ETF, symbol MOO. MOO is up 56 per cent in the eight months ended Feb. 28, COW is up about 50 per cent in the same period, but nothing is forever. COW is traded on the TSX, but MOO is traded on the NYSE and therefore adds foreign exchange risk. Moreover, at some point, market enthusiasm will move on. After all, soybeans are never going to compete with gold for value per ounce.
As to timing of entry into the market, one can only think back to 1999. In the midst of the tech boom, the mutual fund industry was busy creating dot com funds precisely as they were about to fail. Will history repeat itself? Perhaps not. There is a foundation for commodity funds that dot coms, which often had no earnings, sales or even business plans, never had. In the midst of an inflation push by commodities, a small investment in a mixed commodity fund may seem wise.
Alternatively, a play for investors who want some risk exposure that is not linked to the fortunes of Canada is to put money into emerging markets bonds sold through bond funds. Buying emerging markets bonds themselves is very difficult for Canadian private investors, but emerging markets bond funds are accessible. The sector is volatile and some funds expose investors foreign exchange losses. There has been a selloff lately and unit prices of emerging markets bond funds are now more attractive than they were in November. The sector has returned about five to seven per cent for a few years. Bank of Montreal offers the BMO Emerging Markets Bond Fund ETF hedged to the Canadian dollar with a 0.60 per cent management expense ratio, which is not too high for this sector and for a fund that hedges currency exposure.
Finally, there is a standby strategy that works over time: buy stocks that have solid and rising dividends. Even if you overpay, rising corporate earnings and dividends will eventually turn what seems an overpriced investment into a wonderful buy. As the old saying goes, it is not timing the market, but time in the market, that matters. For an investor with a 20 year horizon, it matters little if Royal Bank common shares are $55 or $65. In 2031, either price is likely to be the stuff of tales told at the fireside. One can’t say that with certainty for commodity funds, which tend not to pay dividends, and which are not going to rise at 50 per cent per year forever. May the investor beware.
AndrewAllentuck’sbestsellingbook,When CanIRetire?PlanningYourFinancialLife AfterWork,wasjustpublishedbyPenguin Canadainpaperback
As the old saying goes, it is not timing the market, but time in the market, that matters