Colin S. Ritchie

Feb 8

Advanced Mixology: The Strategic Use of Retirement Assets

(Or How to Thwart the Taxman, Maximize your Retirement Dollars and Sleep 18% Better)

When talking to with retirees, wanna be retirees or children helping their older parents manage their nickels, dimes and c-notes, it’s almost certain that the best way to deplete retirement assets will be part of the conversation. And, that’s exactly as it should be. A well-thought-out retirement strategy can lead to staggering tax savings, greater flexibility and, most importantly, the ability to sleep that much deeper at night knowing that you’ve done as much as reasonably possible to achieve your financial goals, which seldom means making unnecessarily large contributions to our friends in Ottawa.

I’ve written about many different aspects of retirement planning in previous articles, including a series on RRSP / RRIF withdrawals, but I wanted to pull a bunch of different ideas from my previous efforts together, along with some new points to help anyone faced with these conundrums.

What This Article Can’t Do

Despite my strong wishes to the contrary and no matter how pretty or detailed any cashflow projections may look, retirement planning remains a series of educated guesses, many of which will ultimately be off the mark, often within days. How many people predicted the huge spike in inflation following Covid? What about the changes to capital gains taxation in the last Federal Budget? Or the changes to small business taxation over the last 10 years? These examples do not even speak to the more obvious unknowns, like lifespan, income needs and investment returns. Moreover, on that last subject, those of you that have read my previous article on how the “sequences of returns” generated by your portfolio affects your long-term results, you’ll also know that all 7% average portfolio returns are not created equal – bad returns early in retirement can have a disastrous impact on later portfolio sizes, particularly if forced to liquidate capital during the downturns, regardless of later market corrections.

Accordingly, despite my wishes to the contrary, I cannot provide a one-size fits all roadmap, nor can I guarantee that any perfectly plausible plan I prepare today will still be the best way forward if one of life’s surprises strikes you squarely between the eyes. On the other hand, there are a lot of common-sense principles, mixed in with some basic math, that I think can help tilt the odds in your favour. Moreover, the larger your nest egg, the shorter your expected timespan wandering this wonderful world, and the more pessimistic your projections of things like investment returns or spending needs, the smaller the chance of things going drastically awry. Accordingly, despite my dire proclamations, I firmly believe that the benefits of proper planning can usually help you cope with future surprises, provide wiggle room if you need a little more or earn a little less, and hopefully still save a lot of taxes along the way. Although we can’t predict the future, making reasonable assumptions, taking proactive steps and regularly reviewing your numbers are far better than merely shutting your eyes and hoping for the best.

Basic Philosophy

Noting all of these caveats and qualifiers, here are some of the things to consider when constructing your retirement funding plan.

Be Inflexible About Flexibility

As the future is impossible to predict, it’s vital to build flexibility into your plan. Flexibility can take many forms, such as:

Having enough liquid assets that can be accessed without triggering a huge tax bill in case of emergencies, or you don’t want to necessarily wait until you’re pushing up daisies before helping your kids and grandkids. It’s even better if these are in addition to a max-funded TFSA, as using the TFSA to pay for emergencies can carry a huge opportunity cost, since this is the one retirement account that both grows and pays out completely tax-free. In some cases, as you’ll see when I throw some math in your general direction, it might even be better to bite the bullet and pull money from your RRIF instead or borrow.
A HELOC is a great insurance policy. Even if you have the money to pay for big expenses personally, it can sometimes make sense to borrow instead. For example, for a big expense coming due in December, borrowing to pay some of the cost so you can spread out and minimize the tax hit by triggering gains or withdrawing RRIF dollars over multiple years can save you far more in taxes than you pay in interest. The HELOC also provides you with some breathing room while waiting for a market recovery before selling or waiting to sell real estate.
If a couple, plan for what finances will be like if one of you is on their own for many years. A lot of couples minimize their taxes and keep both their OAS pensions while both are above ground, but the survivor is often left dealing with a double whammy of less retirement income if all or most of the deceased’s pensions disappear, but a higher average tax rate on the reduced income since it is taxed on a single tax return. In many cases, it’s worth considering pulling out more RRIF money while you’re both hale and hearty so it can be split across two tax returns if concerned about the survivor being forced into higher tax brackets, or dealing with OAS clawback if you have accumulated significant RRSP/ RRIF savings.
Be willing to adjust your plans if a butterfly in Asia flaps its wings and throws off all of your previous plans off kilter. That means reviewing your situation from time to time and ensuring that you’re up to date with any external factors, like changes to tax rates or law that might mean that it’s now better to zig than to zag.
Be a pessimist. Run any projections on the basis that your investments just might not average 10% per year, you live to 100 and all of those dream vacations cost a little more than you expect. CFPs are required to run retirement projections using rates that might not top 5% and I suggest running one batch of retirement projections on this basis. At the very least, when making assumptions regarding investment returns, run projections using a range of assumptions and, if possible, use a Monte Carlo simulation rather than assuming your investments earn a constant yearly rate of return. A Monte Carlo simulation will randomize each year’s investment returns around your target return, with the maximum yearly high or low capped by how much you estimate returns might vary. The program might run 1,000 different projections, graph the results, and let you know what percentage of these projections didn’t result in you moving into your children’s basement and subsisting on cat food.

Income is Wonderful Thing, Particularly if Tax Efficient

I previously mentioned the impact of your sequence of returns on your retirement portfolio, particularly if you don’t own a yacht. The more income your portfolio generates, the less capital you’ll need to liquidate to pay for golf and groceries. This goes hand in hand with a well-diversified portfolio that is designed to minimize volatility. That said, all types of income are not created equal. Interest income can be taxed at over 50% in some provinces in the hands of the well-to-do. Investing in interest-paying investments in a non-registered portfolio can accordingly come at a steep price, compared to other types of investments that can compound tax-free until needed. Instead, investments that pay eligible dividends are almost tax-free until your taxable income approaches the OAS clawback threshold in some provinces, which is around $93,000. In fact, if in the lowest tax bracket, eligible dividends can actually reduce your tax bill unless you’re receiving GIS, in which case, earning eligible dividends can be a financial disaster.

There are also investments that pay regular distributions through capital gains, such as covered call funds, and, even better, other investment that pay “return of capital,” which is treated as a return of your original investment dollars and is thus tax-free, although it will increase your eventual capital gains bill when selling down the road. Private Real Estate Income Trusts (“REITs”) can provide return of capital distributions in the mid to high single digits and, since they are not initially taxed, they don’t need to generate as much income as less tax efficient investments to pay your hydro bills since, until you sell or are a long-time owner, what you receive is what you keep. Moreover, their tax efficient nature also allows retirees wishing to draw down their RRIFs the opportunity to withdraw more than would otherwise be possible at lower rates or without triggering OAS clawback.

Turning to Registered Plans, I suggest owning more of the interest payers, such as GICs, Mortgage Investment Corporations, bonds or bond funds, and Structured Notes, in those accounts. All types of income are treated the same in these accounts and these types of investments are generally very low volatility. Accordingly, since you’ll eventually be forced to make withdrawals from your RRIFs at one stage, regardless of your need or market conditions, owning these steady eddy investments in your RRIF also minimizes the impact of sequence of returns, particularly if you can increase withdrawals during bad times while you give your stock portfolio the time to recover.

And, if your investments don’t generate enough after-tax money to cover the life you wish to live, having a portion of your portfolio in low volatility, non-registered safe investments that you can use in a downturn can minimize sell low scenarios. Although I hate the opportunity cost having too much money in low, tax inefficient investments and would suggest not overdoing this unless you’re a very conservative investor, having some safe money to draw on when your stock portfolio is down 15% makes sense if your last name isn’t Musk.

Prioritize your TFSAs over your RRIFs

Although there are exceptions to this rule, particularly if the plan is to quickly replace any TFSA withdrawals the next year, I really like continuing to fund TFSA throughout retirement and instead draw down RRIFs. Returning to my mantra of flexibility, having a pot of money that can be accessed tax-free and later replaced is a wonderful thing. And if one spouse dies with a fully loaded TFSA, it can continue to grow tax-free in the survivor’s hands. Moreover, if the survivor never needs the funds, prioritizing preserving TFSAs over RRIFs can ultimately mean more after-tax dollars for future generations, particularly if tax rates continue to climb.

I was puzzling through the issue of trying to best explain the benefits of pulling money from a RRIF instead of a TFSA for living expenses despite OAS clawback for retirees who will likely pay tax at the highest rate at death and came up with an easy comparison. Assume you need $55,000 per year to fund lifestyle and can either draw $100,000 from your RRIF, which assumes a 45% tax cost, or $55,000 from your TFSA for free. In both cases, also assume that all your investments will double by the time you die in 10 years and you currently have $100,000 in both your TFSA and RRIF.

If you withdraw $100,000 from your RRIF but leave your TFSA intact, you’d have $200,000 after tax at death in your TFSA even though your RRIF is kaput. On the other hand, if you left your RRIF intact and withdrew $55,000 from your TFSA, you’d be left with $45,000 in TFSA dollars which will grow to $90,000 at your death, plus $200,000 in your RRIF. If you have to pay tax at 50% at death on that RRIF, however, you’d only be left with $100,000 after taxes. Adding the two accounts together, this totals only $190,000. In other words, if you are able to get the money out at a lower rate now than at death, I suggest taking in from your RRIF rather than your TFSA. My example has the TFSA hoarder passing on an extra $10,000 (5%) to his heirs on the last death. If able to withdraw RRIF dollars at less than 45% during life or paying more than 50% at death, the advantages of melting down the RRIF are even greater. Accordingly, consider funding your TFSA during retirement, even if it means pulling extra money out of your RRIF to do so, if you expect to be in higher tax bracket at death than right now.

As a first aside, it’s important to factor in OAS clawback to these calculations. Although retirees lose $.15 of their pension per dollar for each dollar their income exceeds the clawback threshold, they would have had to pay tax on that $.15 anyway, so the true impact isn’t quite so high. For example, if in a hypothetical 33.33% tax bracket, a retiree would really be out of pocket $.10 (33.33% of $.15) after taxes for every dollar clawed back. Accordingly, the total tax impact of this retiree losing some of her OAS in this scenario is 43.33% (33.33% marginal tax rate +10% extra in OAS clawback.) In some cases, after losing their entire OAS pension and no longer dealing with clawback, some retirees actually pay less tax per subsequent dollar of income until pushed into the highest tax brackets. Ultimately, unless your income is already so high that you consider your OAS pension a lost cause, it’s vital to consider the impact of the OAS clawback when creating a withdrawal strategy.

As a second aside, if comfortable with your own financial situation, consider using some of the extra RRIF money to fund your children or grandchild’s TFSAs or FHSA, or helping them fund another common tax-free growth investment – their home. If the kids are going to get what’s left anyway and you’re confident that you can’t spend all that you have, paying some tax now to fund their TFSAs or homes can make your money go further than waiting until death if you can access the money now at a cheaper rate than down the road. Moreover, gifting with warm hands rather than cold ones allows you to actually witness the fruits of your generosity and, in many situations, a smaller gift now can actually be more impactful than a larger gift later when your kids or grandkids are no longer living in basement suites or struggling with barely affordable mortgages.

As a final point, if you expect to outlive your RRIF, noting that the tax rules currently require 20% annual withdrawals from age 95 onward, you may not need to be in as big a hurry to liquidate your RRIF. Let’s change the previous example to assume that the tax cost of withdrawing the RRIF early remains at 45%, but that the tax cost at death is only 40% because your RRIF is a lot smaller by that point. Using the $100,000 TFSA and $100,000 RRIF scenario discussed earlier, an untouched TFSA would still be worth $200,000 at death, but the smaller TFSA and untouched RRIF would be worth a combined $210,000 net of taxes because of that lower tax bill at death on the RRIF. Ultimately, the right amount of extra money to withdraw (or not withdraw) from your RRIF is extremely situation specific. Crunch the numbers, make honest assessments of your situation and be willing to make course corrections if your investments over or under perform or if you no longer feel confident that you will be tap dancing on your 100^th birthday. If in doubt, my bias is to lean towards the solution that provides you with the most financial flexibility.

As a postscript (yes, I know I promised that the previous paragraph would be my last,) if there aren’t enough dollars to maximize one spouse’s TFSA or if it necessary to make TFSA withdrawals, consider playing the odds. At death, the deceased’s TFSA room vanishes, whereas any TFSA they pass along to the survivor can continue to grow tax-free. Accordingly, if there is a big age between spouses or one of you is looking decided more peaked, consider prioritizing funding or preserving the older / less healthy spouse’s TFSA. On that spouse’s death, the survivor would still have their own unused contribution room to use up if funds permit, plus the deceased’s fully loaded TFSA. I’ve even suggested drawing down the healthier spouse’s TFSA to fund up their partner’s account in extreme situations, such as when that spouse has a terminal diagnosis.

RRIFs vs. Non-Registered Dollars

Assuming your TFSAs are already at capacity, and you’ve already helped your descendants as much as is prudent and affordable, whether it makes sense to accelerate your RRIF withdrawals versus melting down your non-registered portfolio involves more convoluted cogitations. While both RRIFs and TFSA allow tax-free compounding, the same is not true for non-registered portfolios except if a buy-and-hold investor that focuses exclusively on capital gains, thus receiving no dividends along the way. In other words, if your TFSA or RRIF portfolio might double before death, a non-registered portfolio owning the same investments might only grow at 75% due to the increased tax drag resulting from rebalancing and income generated and taxed along the way. Moreover, don’t forget the tax cost of withdrawing money from a RRIF in the first place, which means that much less to reinvest, which might encourage you to draw down the non-registered account first in some cases.

I’ve talked about this issue in previous articles and suggest diving into my article archives if looking for more information on the subject. The magic mix of RRIF withdrawals, whether to fund lifestyle or to merely reinvest the funds in a non-registered account, varies from situation to situation, but some of the things to consider when mulling over these matters are as follows:

What is the tax cost of getting RRIF money out now vs. leaving well enough alone? If you’re expecting to pay a lot more per dollar in the future, including through OAS clawback or in your terminal tax return, paying the piper ahead of schedule may still be your best option even if you don’t look as wealthy on paper at the end of the current tax year and your non-registered money won’t compound as quickly as your tax-sheltered loot.

What types of investments would you sell inside your RRIF and what is their tax treatment if repurchased in a non-registered account? Dividend paying stocks owned inside a RRIF don’t benefit from either capital gains treatment or the dividend tax credit. Accordingly, selling these assets inside a RRIF and repurchasing them with what’s left after appeasing the tax man might eventually allow you to come out ahead. For example, a BC resident earning $80,000 per year would pay less than 2% tax on dividends from her non-registered portfolio each year vs as much as 53.50% at death if those dividends remain in the RRIF, continue to compound, and are eventually taxed at the highest rate. Although those dividends aren’t growing tax-free in the non-registered portfolio in this example, paying a token amount of tax each year along the way is a far better alternative than the estate having to pay through the nose when the grim reaper makes a house call. By the same token, if the same investor is the buy and hold type, (s)he might avoid paying any tax on the growth for many years or even until death, where the tax hit if in the highest tax bracket might be as little as 50% that tax payable on the RRIF balance, depending on how capital gains are taxed at that time. Although this retiree’s investment portfolio may not look as sexy during his lifetime as a neighbour who hangs onto her RRIFs until the bitter end, his heirs might ultimately be the ones able to afford the bigger casket.

Using my earlier hypothetical $100 RRIF and assuming both neighbours had identical RRIF investments and died at the same time, if the parsimonious neighour’s RRIF doubles prior to death but is then taxed at 50%, her devastated descendants would only net $100. If the savvy gentleman down the road withdrew the same $100 from his RRIF while in a 30% tax bracket to reinvest in a non-registered account where it compounds by only 75% until death, where the $52.50 gain is taxed at 26.75%, his initial $70 investment would be worth $108.46 net of tax at his passing. Conversely, had he instead invested his $70 in a GIC, the numbers wouldn’t look nearly as good, although perhaps still acceptable. Assuming his $70 GIC portfolio grew by only 50% prior to death due to the increased tax drag, he’d still have slightly more than $100 at death, which would be the only year when taxed in the highest tax bracket.

What is the tax hit from selling some of your non-registered portfolio? Although you won’t pay as much tax per dollar on capital gains vs. RRIF withdrawals, if you’re up big in your non-registered portfolio, you might be better off letting those investments continue to flourish, depending on some of the other factors in this list. Of course, don’t let tax considerations block out investment considerations – if the signs suggest that it’s time to sell a stock despite its past performance or it represents too large a share of your portfolio, don’t be afraid to pull the trigger despite the resulting tax hit.

How much is flexibility worth to you? Slowly pulling out RRIF funds over time to build up a non-registered war chest to provide more wiggle room for larger expenses later or to allow more gifting during your lifetime may eventually be worth your while even if there are no immediate benefits, other than perhaps a bit more peace of mind.

What would you do with extra RRIF withdrawals? What is the after-tax return or savings if using the cash to pay down or avoid incurring debt, buying life insurance that grows and pays out for free or helping future generations? If planning to reinvest in your own name, early withdrawals to purchase GICs is far less appealing than paying down high interest credit card debt.

How much longer do you expect to remain above ground? The shorter your remaining lifespan, the smaller the opportunity cost of triggering taxes ahead of schedule, particularly for RRIF withdrawals that will ultimately be fully taxable at death.

When looking to sell non-registered winners, don’t forget to also harvest losers as well to negate all or some of the taxable gain. Moreover, if triggering a large gain will push you into the OAS clawback zone or a really uncomfortable tax bracket, consider selling in stages over multiple tax years to reduce the tax pain if there isn’t a compelling investment reason to sell the entire investment now. If approaching the end of the year, selling some in December and more in early January might make a big difference to your bottom line in some circumstances.

Conclusion

There are myriad moving parts to take into account when strategizing how to draw down income during retirement and, as is so common, one size does not fit all. Knowing your options, how the tax system works and using somewhat pessimistic assumptions that are fact-checked regularly can go a long way to making the most of your retirement assets and improving the quality of your sleep.

I will have more to say on these matters in future articles, particularly for those you who also have corporate savings to draw upon during your golden years.

Apr 10

Making the Right Call: The Ins and Outs & Ups and Down of Covered Call Funds

As I’ve said many times before, few things in the investment world make me happier than receiving nice fat deposits into my investment accounts on a regular basis. I may have never been to Mississippi, but I strongly suspect that I’d have a strong affinity to the Show Me State.

I get even more excited when I know that I won’t have to share too large a portion of those juicy payments with the government come tax time. As I have been known to repeat ad nauseum, it’s not what you make, but what you keep after fees and taxes that really matters. Inside registered accounts, all distributions are treated the same. Accordingly, it’s irrelevant how you make your money in such accounts, so long as it’s an appropriate investment for your temperament and circumstances. On the other hand, how you get paid inside a non-registered account, whether in your personal or a corporate account can matter a heck of a lot. That’s where covered call mutual funds or etfs (I’ll use “funds” to describe both hereafter) might really shine.

Background

Put in simplest terms, a fund that “writes” or sells covered calls trades some of the potential upside from the stocks they are selling call options on in exchange for an upfront payment called an “option premium.” Using an example, if you own a stock worth $100, you might sell someone the right or option to purchase that same stock from you for $103 any time over the next month in exchange for an extra $.50 right now. If the stock never hits this value, the option will expire as worthless and the person purchasing the call will be out $.50 with nothing to show for it. You, on the other hand, will get to keep the stock, any dividend income paid on it, plus the up-front $.50 option premium payment. And, if you’re so inclined, you can start from scratch and sell another call option the next month.

Conversely, if the stock soars to $105 prior to the option expiring, you will be required to sell at $103 (or buy back the option) and miss out on that extra $2 of profit. So, although you are stuck selling a stock worth $105 for $2 less than market value, you still realized a $3 on the increase of value, any dividends issued, plus the $.50 option premium. Accordingly, although you didn’t do as well as if you hadn’t sold a call option or the person who purchased it who and made a 300% profit, you still have a lot to smile about. And, if you’d been collecting options premiums on that same stock for several months before it was “called away,” (forced to sell your stock at the price stipulated or “strike price”), you still might still be ahead of the game compared to simply buying and holding that stock.

Finally, if the stock goes down over the call period, although you’re probably not too happy about this, at least you’re $.50 better off from receiving the call premium than the guy down the street that owed the same stock but didn’t write a call. And, if you were a retiree on tight budget, the extra $.50 in call premium per share may mean not having to sell as many shares during a setback to pay for groceries. In summary, covered call funds usually underperform typical funds in a rising stock market but the higher income they generate vs. owing a similar basket of individual shares might be very attractive to more risk-adverse or income-hungry investors more interested in monthly payments than growth.

Option Pricing Basics

In the example I provided, I arbitrarily pulled numbers out of the air in order to explain the general concept. The value of any call option is highly variable and is affected by the following:

The prospects and volatility of the underlying stock: A stock that goes up and down like gymnast on speed generates a higher premium than a staid blue chip special, as the upside if the riskier stock catches fire during the option period is that much higher and, thus, enticing.

General Market Volatility: As you might expect, not only does a specific stock’s volatility affect what you can charge for an option premium, but so does that of the stock market as a whole. For example, options premiums will be a lot higher during an event like a global pandemic than when all is sunbeams and moonshine.

The Length of the Option Period: If you write an option that lasts 3 months, you should be entitled to a higher option premium than writing one that lasts a single month, since whoever purchases the option has three times as long to strike it rich and for a hot stock to keep on climbing.

The Difference Between Strike Price and the Stock’s Current Value. In my example, the “strike price” of the option was $103 for a stock currently trading at $100. If the strike price was only $102, the option premium will be higher since there is that much better price of the option eventually “being in the money” and rewarding the buyer. Likewise, as you’re agreeing to surrender more of the upside if pricing the strike price close to the current value, it only makes sense if you’re paid more in exchange. Finally, the increase in the option premium as the difference between the strike price and market price decreases can increase significantly as buyer risk goes down and seller opportunity cost rises. Accordingly, if the seller in my original example was selling a call option for $101 or even one that is already “in the money” such as a $100 call option, they should expect to get significantly more than the $.50 option premium from my example.

Advanced Lessons

As you might expect, things are not quite as simple as the example I’ve described above when looking at this strategy inside a fund versus on a single stock basis. Different companies have different strategies, so it’s important to understand how the various funds differ from each other before deciding on what does (or doesn’t work) best for you. Here are a few of the things to consider:

Do you believe in that market sector? In basic terms, if you don’t like the sector, don’t chase the income stream on the related covered call funds, or at least limit your exposure. And, even if you like the sector, beware of too much of a good thing in case your hunch doesn’t pan out. Consider a basket of different covered calls funds with different holdings or look into funds that do this for you rather than merely buying sector specific funds.

On what percentage of the fund are they writing calls? Most covered call funds don’t write calls on the entire fund. Accordingly, the more shares that aren’t optioned, the more potential upside in a rising market vs. a fund that has written calls on a higher percentage of its holdings. When comparing funds, take this into account rather than merely focusing on yield. The higher portion of a fund’s shares that aren’t optioned, the better the upside in a rising market.

What is the maximum percentage of a fund that can be optioned? Many funds target a set yield and will write just enough options each month so that the combined dividend and covered call premium yield generates the desired yield. Accordingly, in more volatile times, a fund may not need to write as many call options to hit their yield targets if each call option pays a higher option premium than during a quieter market. That said, funds may also restrict the maximum percentage of shares optioned at any one time. One way or the other, it’s good to know both what’s going on right now and the limits on how much can ultimately be optioned away if circumstances change.

What is the fund’s typical spread between the market value of the shares optioned and the strike price of the options and how variable is this? As explained earlier, the tighter the spread, the higher the option premium. In fact, some funds have recently started selling call options that are “in the money” or where price for exercising the option equals the market value of the share. I’ve seen funds like this generate income of the mid-teens but it’s important to remember that you will be giving up the entire upside on all optioned shares in that scenario, which may sting in a rising market. Conversely, when the market hits the skids, these funds should outperform similar options-free funds. Returning to the previous bullet, it’s also vital to know what percentage of the underlying stocks are optioned, as the non-optioned portion of the fund can still appreciate during a rising market. Accordingly, unless the market has gone gangbusters, to use a technical term, such funds may still hold their own when the market enjoys modest but not monumental gains.

Do the funds use leverage? There are several covered call funds out that borrow to purchase perhaps 25% more of the underlying shares, using the extra dividend yield from the extra shares and covered call premiums to cover the borrowing costs. This might allow the funds to more fully participate in rising markets if it means less of the underlying shares are optioned but are more likely to take it on the chin when the market falls. I would also expect that as interest rates decrease and the fund’s borrowing costs decline that such funds would not need to write as many options to generate the target distribution, further increasing their performance against their covered call peers in a rising market.

How long has the fund been around and what’s its track record? The new breed of covered call funds that issue “in the money” options has captured a lot of interest but it’s really hard to gauge their performance against both other covered call funds that employ less aggressive option writing strategies and against more traditional funds that don’t employ options at all. The high yield is amazing and may be answer enough for some, but it’s hard to make an accurate basis of comparison without the necessary historical data. The study I discuss later in this article raises some concerns regarding traditional covered calls. Although a juicy yield is a wonderful thing, keep an eye on the fund’s overall performance. Even better, look at its long term track record if one exists.

Fees! What does any fund charge compared to its peers?

How is the fund’s target distribution typically taxed? In a non-registered account, the distribution from a covered call fund is likely a mix of things. The options premium portion is taxed as capital gains. Depending on the underlying assets in the funds, some of the income may also be eligible dividends, interest income, foreign income or tax-deferred return of capital. Although interest income is usually the least desirable, a lot depends on your tax bracket, as eligible dividends may be disastrous for investors relying on the GIS, nirvana for those with slightly higher tax brackets and not nearly as good as capital gains for investors making the really big bucks. While an investment’s raw yield usually grabs the headlines, knowing what you’ll ultimately get to keep after taxes can help you make a more informed choice. That said, it’s a dangerous thing to make investment choices solely by focusing on taxation.

Additional Thoughts and Arguments Against

There are concerns in some quarters that the chase for option income can actually reduce total returns, such as identified in Larry Swedroe of Alpha Architect’s November 24, 2023 article (A big thanks to Moneysaver reader Dave Reid for sending this along!) That article compares the performance of some covered call funds vs. similar funds that don’t use this strategy and cited another study that concluded that over the study period (1999-2023) that a Nasdaq-focused covered call etf didn’t do nearly as well as a standard, cheaper etf tracking the same index. It also pointed out that a standard etf may be more tax efficient since more of its return translates to deferred capital gains. Finally, it also concluded that the smaller the spread between the option strike price and the stock’s trading price at issue, the worse the fund’s overall performance. In other words, the income from the call options didn’t fully compensate investors for surrendering upside.

This article raises many good points, although I would have loved to have seen a Canadian-based example. In an example where the underlying Nasdaq stocks averaged over 16% annual growth, it is no surprise that the covered call version drastically underperformed.

In defense of covered calls, I think that merely focusing on the total return can also lead to “sequence of return problems” for investors dependent on their portfolios to pay for their daily bread. As I’ve written about previously when discussing the “sequence of returns,” or when an investment has its good vs. bad years rather than its overall performance, having to liquidate stocks during a correction to pay the internet bill can have a disastrous impact a portfolio’s long-term performance, as it forces investors to “sell low.” Such investors may not have the luxury to wait until the stock market cooperates and might instead appreciate a higher income along the way, particularly if they don’t need to shoot the lights out to stay on track for their ideal retirement.

Conclusion

Ultimately, like in so many areas of life, there are pros and cons to every decision. Although wealthier clients with a long time horizon, higher risk appetite and no need to generate extra income may do better with more traditional funds, more income-dependent or conservative investors may look at their investment options very differently. And, if you are one of them and are considering covered calls to help ensure that you have enough to fund your monthly premium peanut butter habit or to sleep soundly at night, I hope this article has helped in your investigation.

Dec 11

Taking Note of the Possibilities: Auto-Callable Contingent Income Notes

I have a confession to make – I’m fussy about surprises. I’d much rather save them for birthdays and major holidays than when reviewing my investments. Admittedly, volatility can sometimes be an investor’s best friend, such as when that a penny stock is suddenly worth dollars, these happy surprises are outweighed by the times things go the other way, which leaves me feeling like I’ve just found out that Christmas was cancelled while sitting on a piece of birthday cake. And, for investors who are on track for a comfortable retirement, are tired of getting motion sickness when tracking the ups and downs of their stock portfolio or are already in retirement and can’t afford to get it wrong, you should feel the same way.

I’ve previously written about how volatility when you have your good vs. bad investment years (your “sequence of returns”) can have a profound effect on the eventual size of your portfolio, particularly during retirement when you might have to “sell low” to pay for golf and groceries. On the other hand, I’ve not written nearly enough about some of the other risks investors have when saving for retirement, such as running out of money due to not taking enough investment risk: GIC investors, this might mean you! If your money needs to last you through 30 plus years of retirement, settling for investment returns that might not even keep up with inflation after including taxes potentially means tough times if you live into your 90’s (or 100’s if some of those alleged medical advances actually pay out) unless you’ve got other assets that pick up the slack or have either have or will later inherit a healthy nest egg.

Structured Notes – What Are They?

Although I love the regular income that GICs can produce and appreciate the peace of mind that comes with the typically complete capital protection, I’m willing to take a bit more risk to hopefully reap a lot more reward. Although there is no silver bullet perfect for every occasion and every market, I’ve found a few tools that can produce a significantly higher income without dramatically increasing the risk of getting birthday cake on my snazzy new pants. In other words, while I’m taking on more investment risk than a GIC, I’m also giving my portfolio a chance to at least keep up with inflation to combat longevity risk, — otherwise known as the possibility of having to survive entirely on bologna sandwiches later in life. Today’s offering talks about one of these tools designed to thread the needle between investments that are too unpredictable and those that too stingy: auto-callable contingent income notes, a subclass of a class of investments known as structured notes.

In general, structured notes are investment products created by banks that track the performance of underlying investments and pay investors according to how that particular underlying basket of investments performs. The banks issue a bunch of different notes with different potential returns based on different underlying investments, ranging from the performance of the entire TSX, a basket of a few stocks, such as the big 5 banks, or even the performance of a single stock, such as Tesla.

In many ways, structured notes are like betting on sports, although with typically far less risk than overzealous Leaf fans may have experienced over the years. The banks offer an ever-changing array of notes, each with different potential outcomes and levels of risk, depending on current market conditions. Investors investigate the different notes and place their bets based on their assessment of risk and return. Like any good bookie, the banks cover their risk by purchasing options or zero-coupon bonds in the investment market that match the terms of the notes on offer so they are not out of pocket if the investors win. In fact, both the banks and the investors have something to celebrate if this happens– since someone else will ultimately be financing the investors’ profits, the bankers are still smiling because they got to use the investors’ money along the way, minus the cost purchasing the protection, to do bank-like things, like lending it to other clients or investing it for their own profit.

Although there are a wide variety of notes on the market, I just want to talk about one type– auto-callable contingent income notes, a name obviously not chosen by an advertising professional. This product provides a regular income stream provided that the underlying investments doesn’t drop below a predetermined limit. It is typically considered a hybrid of both stocks and bonds – the returns are based on the performance of stock, but investors don’t participate in the growth of the underlying investments (although there are other structured notes that offer this feature if you’re so inclined.) Instead, investors get a constant payout for each specified period (such as monthly, quarterly or annually), much like a bond unless the underlying investment has dropped more than a preset amount as of a specific day. Also, unlike stocks, any proceeds from notes are almost always taxed as interest.

The Value Proposition and an Example

The best way of truly describing this class of notes is by way of example. Although I’ll recklessly throw some investment jargon your way, keep reading and hopefully all will soon become clear. A typical note issued in today’s high interest and uncertain times might offer 12% annual income paid monthly (each payment is called a “coupon”) based on the underlying performance of a basket of Canadian banks with a 30% barrier and a 30% partial maturity guarantee when the note matures in 7 years (although 5- and 3-year maximum lifespans are also common) with a 110% autocall feature. Translating into English, this means that so long as your basket of bank stocks hasn’t declined in value more than 30% from the date the note was issued on a preset day each month, you earn that month’s interest coupon. If, instead, financial Armageddon hits and your basket of banks is down 35% on the day in question, you miss that month’s payment. The next month, however, if the banks have rebounded even slightly to 71% of their original price, you earn that month’s income, although last month’s lost interest remains lost and gone forever most of the time.

This monthly calculation continues until one of 2 things happen – either the underlying basket appreciates by more than 10% of its original value (the “autocall” price) or 7 years have passed and the note “matures.” In the first scenario, investors get their final interest payment, plus all of their original investment back as of the month the basket hits its target growth rate. In the second situation, it all depends on the value of the basket at the time of maturity, plus the amount and type of downside protection purchased. In the example I’ve given, which is a 30% “barrier,” at maturity, if the basket is worth at least 71% of the original value at that time, then the investor gets a full refund of the original purchase price and their final interest payment. On the other hand, if the investment is only 69% of the original value, then they would only receive $69 of the original note. Put another way, this investor gets all their money back so long as the underlying bank bundle hasn’t declined by more than 30%, but, if it has, they are on the hook for the entire loss.

If the latter outcome is too risky for your blood, you might purchase a note with a “buffer” instead. While a barrier provides protection if the loss is within a certain range, buffer notes offer protection even if the loss exceeds the preset threshold. Using my previous example, if you owned a 30% buffer instead of a 30% barrier and the basket was worth $69 at maturity, you’d still get back almost all of your original investment, although your monthly interest payments would likely have been less than those offered through a barrier note. As you’d expect, you pay for this extra protection by accepting a lower yield since the bank has to buy more expensive protection to cover the potential loss.

Other ways to Protect Yourself

Although buying a buffer dramatically reduces downside risk, that is not the only way of increasing your odds of a positive outcome. Here are some other tactics to increase the chances of a happy ending:

Increasing the size of the buffer or barrier. Is 30% not enough protection to protect the quality of your nightly slumber? Consider buying 40% downside protection instead, both to protect your regular income and how much you’ll get back if the note isn’t redeemed until maturity.

Purchase notes with a memory feature. Although being under water on the observation date typically means losing that period’s payment forever, notes with a memory feature allow you to play catchup. Once the note is once more above its barrier or buffer on a future observation date, the investor gets both their regular payment plus any payments they may have missed in the past.

Buy notes that go low. There are occasionally notes that calculate the initial value of the note for future observation date purposes based on lowest value of the underlying bundle within the first observation period. For example, a note with a semi-annual coupon based on the TSX with a 30% barrier with this additional feature would pay that half-year’s coupon so long as the value on each observation date was at least 70% of the value of the TSX at its low point during the first 6 months after the note was issued rather than the bundle’s original value at the time the note was issued.

Opt for monthly coupons. If there is a precipitous decline in the value of the underlying investment on an observation date, it’s far better if you only miss one month’s coupon payment instead of perhaps an entire year’s worth. Different notes offer different payout periods, such as monthly, quarterly, semi-annually or yearly. Since a really bad day in the market on the observation date means not getting paid, picking the monthly coupon option means only missing one month’s worth of income if the investment world is far less dire a month later. Although picking shorter payment periods can cost you the occasional payment if the bundle is underwater for a month or two but rights itself by the end of the quarter or year, I’d much rather accept this risk than chance risking an entire year’s worth of income by selecting a note with longer gaps between payments.

Picking a boring bundle. Hedge your bets by picking a note based on an underlying investment you think is conservative or which you view as already significantly discounted. As an added bonus, because of this recent volatility, notes based on investments with a recent decline generally offer higher coupon payments. Some clients recently purchased notes based on Canadian banks for these reasons, for example. It is even possible to purchase a note based on an entire index like the TSX rather than a specific sector to if you feel that this is a safer bet.

Pushing out the lifespan of the note. The duration of the structured notes can also vary. One school of thought suggests that the further out in time before a note matures, the smaller the chance that the underlying basket will be less than the protection purchased at that time. If you believe that the market ultimately wins in the end, increasing the distance between purchase and the maturity date plays into this philosophy. Moreover, since notes can also be sold on the secondary market, notes with a longer maturity period aren’t as volatile if you need / want to cut bait and sell along the way.

Selecting the autocall carefully. Most notes do not make it to maturity. In fact, the majority are redeemed within a couple years of issue. Sometimes this is a good thing and sometimes, not so much. If you love the interest rate and the underlying basket, look for a higher autocall threshold such as 110% of the original bundle value vs. 105% so you can keep raking in the cash for a bit longer. On the other hand, perhaps you just want to park your money in a note until you feel better about the market and / or don’t love current note rates. If you have an autocall feature where you’re redeemed when the investment climbs by only 5% vs. 10%, you will be bought out potentially far sooner if the investment performs, at which time you can redeploy your capital into either another type of investment or perhaps another note with more favourable terms.

Purchase a note with the right initial observation date. Even if you have a monthly autocall feature, your note will have a minimum initial waiting period before the autocall feature kicks in. If you love your current note, picking perhaps a 1-year initial observation date vs. 6 months may help keep the good times rolling that much longer.

Buy a bundle of bundles. Rather than just purchasing a single note based on a single bundle, spread out your risk by purchasing several different notes based on different underlying investments. In fact, structured note ETFs have recently come onto the market in Canada. Although the one I investigated is too new and has only 20% barrier protection, who knows what will be on offer in a couple years or how existing products have performed.

Pick a note that matches your ultimate time horizon. Although most autocall notes are redeemed within a couple of years and there is a secondary market should you wish to sell, consider matching the ultimate duration of your notes to when you need the money. For example, if investing in a TFSA to purchase a home in 5 years, a note with a 7-year maturity period might not be the one for you. As stated earlier, however, if you really need the cash, there is a way out. In fact, structured notes may be cheaper to unload in some situations than non-cashable GICs, depending on how your note is priced in the secondary market.

Don’t be a one trick pony. No matter how much you like this type of investment, continue to diversify your portfolio with different types of investments. For GIC fans, this might mean combining structured notes with a few GICs as well in order to further reduce your risk. Ditto for those investors who are big on bonds, preferred shares or perhaps other investments like Mortgage Investment Funds, which I see as the main competitors, although each has their own pros and cons.

More Note Planning Tips

In no particular order, here are some more tips to consider when looking into purchasing notes:

Shop around. Not all banks offer the same rates at the same time. If your broker is linked with one of the big banks, make sure that (s)he also looks at what the competitors are selling.

Realize that notes pay interest and plan accordingly. Although notes are based on an underlying bundle of stocks, all distributions are taxed as interest income. Accordingly, they are best owned in registered plans, family trusts with low-income beneficiaries or by low-income individuals not worried about things like the GIS clawback.

Focus on the big picture when assessing risk. When choosing between this type of product vs. alternatives like GICs, preferred shares and bonds, consider the risk of a note being redeemed for less than full value at maturity but also the extra income you may have received along the way vs. some of these alternatives. It could be that the extra cash received before then from a higher yield, particularly if you have buffer protection that absorbs most of the loss, still leaves you better off than something like a GIC with 100% principal protection but a much lower yield. Do a similar analysis if deciding how to allocate money among investments like notes, bonds and preferred shares, although you’ll also have to factor in the chance of those other options producing capital gains or losses (although this could also arise if trading structured notes on the secondary market.)

Get your broker to custom-fit a note. Like a good bookie, banks are typically willing to create tailor-made notes for the right client if worth their while ($1 million seems to be the minimum note size.) Accordingly, if you can’t find the exact note of your dreams, see if your broker or portfolio manager is willing to work with a bank to create a custom fit. It’s not like you’d have to purchase the whole thing – my own portfolio manager is currently working to create one that a bunch of his clients will share, plus whatever other investors may snap up.

Performance Notes

The following stats, plus many useful tweaks and suggestions, were provided to me by two Portfolio Manager friends at Aligned Capital – Thomas Tsiaras and Wail Wong. A big thank you to both of them for their expert advice.

The following chart pertains to National Bank products from 2016-2022. Our notes of choice, auto-callable contingent income notes, are included as part of the “Non-Principal Protected Notes” family, as opposed to the “Principal Protected Notes.” The first category covers notes that include only partial protection (an average of 32.7% downside coverage) while the second cluster fully guarantees that investors will not lose money.

While the fully protected notes, including market-linked GICs (which are not be confused with your guardian variety fixed income GICs) did ensure that no one lost money, they only produced an average annual return of 3.3%. In contrast, notes with partial protection averaged an annual return of 8% even after factoring in losses. Moreover, the partially protected notes failed to make a profit only 2% of the time, versus 24% for notes with full coverage. In other words, in exchange for taking on this extra risk, which only resulted in neutral or negative outcomes 2% of the time, the investors earned more than twice as much than their more conservative friends, with a higher chance of making money.

Fee Classes

Notes are either sold as “A” or “F” class, just like many other types of investments, either with an embedded commission for the advisor (A Class) or with that commission stripped out, with advisors charging their clients an advisory fee directly (F Class.) As you would expect, F class notes offer a higher yield.

Some advisors may offer clients the choice of purchasing either class of notes – those with a one-time fee embedded into the product but with a yield that is adjusted to cover these costs or those with the commission stripped out but with ongoing advisory fees paid directly, although this will likely require clients who purchase both versions from the same advisor to hold them in different accounts, one managed by the advisor and the other self-directed. In some cases, choosing the Class A notes can even be a win-win for both client and advisor – the lower A class yield may be less than what the advisor charges management fees, but the advisor still makes a healthy one-time commission, particularly if the note is sold or autocalled within a couple years and the clients reinvest the proceeds with that advisor.

Conclusion

Although they have been around for a while, auto-callable contingent income notes are currently one of the trendiest investment options for clients looking for higher yield with some extra protection. Although they may have more moving parts than a caper movie, don’t let that scare you off from putting in the work to see if they have a place in your own investment portfolio. The retirement you save might just be your own.

Dec 11

Is Mortgaging Your Future Necessarily a Bad Thing – Investing in Morgage Investment Corporations

Over the last 2 years, the economic landscape has undergone a seismic shift. Interest rates and inflation have both spiraled to levels not seen in decades – the last time Bank of Canada interest rates reached current levels was prior to the 9/11 bombings. And, although inflation has dipped from its peak, we have still been dealing with inflation not seen since I was in high school, a period long since vanished into the mists of time.

These enormous changes, coupled with recent stock market declines and concerns over further market retreats have left many investors befuddled and bewildered, particularly those looking for fixed income returns that actually do better than inflation after paying off the tax man. Although GIC rates have also risen to the occasion, when both inflation and tax are factored into equation, their buying power is at best treading water and at worst, submerged by the waves. Consequently, many investors are clamouring for higher yielding investments that don’t make them feel like they are plunking their money down at a craps table, hoping not to roll snake eyes.

I’ve recently written on a type of structured bank note with significantly higher yields that GIC with some downside protection but want to spend today talking about another option: Mortgage Income Funds or “MICs.” For the rest of this article, I’ll outline what they are, how they work, and key factors to consider so that you can decide for yourself whether they are worthy of a special place in your life – inside your retirement portfolio. Thanks to Russ Mortgage, mortgage broker extraordinaire, and both Thomas Tsiaras and Wail Wong, portfolio managers at Aligned Capital, who regularly incorporate MICs in their client portfolios, for their valuable input.

The Basics

Background and Basic Features

MICs are investment funds created by the Federal government in 1973 that hold a pool of mortgages and which are required by law to pay out their yearly after-tax earnings to their investors. In return, the government doesn’t make MICs pay tax directly, which means more for investors, unlike most other types of investments, where companies have to pay taxes on their earnings and can only distribute whatever is left (although the dividend tax credit on eligible dividends can admittedly ease the pain in non-registered accounts.)

On the other hand, even though MICs may describe their distributions as “dividends,” they are taxed as interest or income by our friends at the CRA. As a result, MICs are not tax efficient and are often better owned inside registered accounts like RRSPs and TFSAs.

MICs play a surprisingly large role in the lending business. One recent article suggests that there are between $13 and $14 billion invested in MICs in our country and that they account for about 1% of the mortgage market. Another, slightly older, article suggests that there were over 200 MICs in Canada as of 2018. In other words, there are more MICs in Canada, and they are collectively worth far more, than most of us realize.

As you might expect, all MICs are not created equal. Each has its own investment mandate and strategy. Some may lend across Canada, while others focus on distinct geographical areas like the Lower Mainland of BC or Greater Toronto. Some only lend against residential properties while others lend to commercial developers. Perhaps most importantly, some seek higher returns by issuing second or third mortgages while others focus primarily on first mortgages. Different MICs also have different loan to equity rules – more conservative MICS may lend $.65 or less per dollar of collateral while other MICs may be willing to lend as much as $.85 per dollar, and as a result, paying higher distributions. Yet another recent article ranged expected returns across the MIC universe this year between 6 and 12%.

Finally, there is one more significant difference distinction between MICs– some trade on the stock market and are subject to fluctuations in value like a stock, ETF or mutual fund, while private MICs generally maintain a fixed value of $10 per unit so that investors’ total returns will be limited to interest earned. Private MICs are not nearly as liquid as public offerings and don’t have the same reporting requirements, but each investor’s ultimate returns are not dependent on the whims of the stock market on the day he or she decides to cash in. As in so many areas of life, there are pros and cons to any decision.

In summary, all MICs are not created equal and each of us needs to carefully look into the different alternatives before deciding whether or not to invest and, if so, which MIC or which basket of MICs offers you the best mix of safety, returns and quality sleep.

The Business of Private Lending

As you’d expect, people usually turn to alternative lenders when they can’t qualify for a traditional bank mortgage or the banks won’t give them as much as they want. Although poor credit history is always a reason why some people bail on the banks, it isn’t the only one. Here are a few other types of typical MIC borrowers:

Recent Immigrants Recent immigrants may not have been in Canada long enough to establish a sufficient credit history to fit within the bank’s lending box and may need to work with an alternative lender until they have been here long enough to build up the necessary track record.

The Self-Employed and Commissioned Salespersons. The self-employed are generally seen as a big risk, particularly if they have unstable earnings. Likewise, commissioned salespeople are often viewed through a similar lens. Moreover, regardless of how much money someone with a private company may be banking up in a holding company, the banks focus on personal income, ignoring additional corporate earnings that could have been paid out but were not, generally for tax reasons. In some cases, these clients may simply need to bump up their own salaries, work with a MIC in the short term and then circle back to the banks in a year or so. In some cases, the big banks are actually the ones that refer clients to alternative lenders in the expectation that the clients will return to the banking fold in the not-so-distant future.

Quicker Approval. In some cases, property developers may choose to work with private lenders, particularly for shorter term loans because it is easier and faster.

The Mortgage Stress Test and Its Impact

The stress test was introduced in 2018 and has resulted in many potential borrowers previously on the side of the banking angels no longer qualifying for a traditional mortgage, despite solid credit scores. As alternative lenders, such as MICs, aren’t bound by the stress test, they can adopt their own flexible lending policies and fill the gap when the banks say no. Ultimately, this increases both the size and quality of pool of borrowers MICs can choose amongst. On the other hand, many MICs have been growing like gangbusters since 2020, which might erode some of this benefit.

For those of you who are normal people (i.e. aren’t up to speed on all things stress-test), the basic rules are as follows. Borrowers working with the banks must be able to qualify for a mortgage at whatever rate is higher: 5.25 % (this rate is reviewed yearly) or 2% more than what their bank is offering them without using:

More than 39% of their pre-tax income to cover the mortgage and other housing costs, like utilities and property taxes; and

More than 44% of their pre-tax income to towards all personal debts, including the mortgage.

To put how much interest rates have climbed into perspective, the 5.25% is so out of date (borrowers have to be able to sustain mortgages between 8 and 9% as of early December 2023) that most people successfully applying for a mortgage will be paying actual interest that is higher than preset stress-test rate. The rate surge that the 5.25% minimum rate was designed to insulate has now arrived in full force and now seems to have stalled. Accordingly, the stress test has saved many borrowers from a world of hurt or will at least reduce their pain when it is time for them to renew over the next few years by capping how much they were able to borrow when the getting was good. On the other hand, if you believe that we are primed for interest rates to finally start falling or at least not to grow by another 2% over the next 5 years, then you may feel that the stress test is now getting in the way people and banks’ ability to think for themselves. That’s where MICs play a role.

Factors to Consider When Comparing MICs

Although I’ve already discussed some of the key differences between various MICs in passing, here is a more detailed summary:

Type of Mortgages. Different MICs lend against different types of real estate. Some may lend to developers or other investors, while others restrict their loans to homeowners. I personally prefer residential mortgage MICs in the belief that homeowners will move heaven and earth to protect the place where they and their family sleep at night vs a corporate developer that is protected from personal liability if things go wrong.

Geographic Considerations. Some MICs focus on Canadian real estate while others will also lend outside of the country. Moreover, within Canada, some MICs target specific areas, such as BC’s Lower Mainland or Toronto, while others sprinkle their loans further afield. There are different benefits and risks to each approach. For example, a MIC focusing on a specific geographic area may be able to understand that market better than a MIC with greater geographic diversity and may be able to build up better connections and quality of borrowers than a MIC without a homecourt advantage. On the other hand, as all of us investors know, diversification has its own advantages.

Downside Protection / Loan to Value Ratio. How much does the MIC lend per dollar of equity in the property? And, how much extra does a higher paying MIC generate for taking on this additional risk? I generally restrict myself to MICs who lend no more than approximately 75% of a property’s equity, but each to their own.

Priority of Mortgages. Some MICs (often called “Prime Mortgage Funds”) only issue 1^st mortgages while others may blend in some 2^nd and 3^rd mortgages. Determine the mix (see what I did there) of different mortgages in each MIC and how much fits into each category. As well, how much (or how little) yield do you give up by investing in a fund that only provides first mortgages?

Average Loan Size and Number of Mortgages. I believe that the greater the total number of mortgages and the smaller the size of the average mortgage, the better the protection.

Average Value of Borrowers’ Property. I prefer MICs that focus on starter homes, as I see them as more resistant to market drops than swanky luxury pads. As the value of a starter home in Halifax is a fraction of Toronto number or Vancouver values, it’s also a question of knowing what a starter home costs in that MIC’s target area so you can determine if the MIC is focusing on entry level residences or palatial estates.

Leveraging? Some MICS boost returns by borrowing from banks or other lenders at one rate and then lend the money out to borrowers at higher rates. The bank or other financial institution working with the MIC will have done its own due diligence before agreeing to this arrangement and will continue to monitor things closely, but you will need to decide for yourself whether you’re okay with this. I also suggest determining how much a fund is currently leveraged and the maximum amount it can borrow.

Liquidity Restrictions. Private MICs usually have a minimum holding period and only offer redemptions monthly or quarterly, which means waiting another month or two at least from when you want your money back. If a minimum holding period applies, determine the penalty for cashing in your chips early in case your plans change. Private MICs, like other exempt market investments, can also can “gate” or restrict redemptions in exceptional circumstances, such as if too many people want to redeem at once. This is potentially one of the biggest disadvantages of private MICs.

On the other hand, it’s also important to keep things in perspective. Although public MICs can’t gate redemptions, if there is a run on a public MIC, expect to sell at a significant discount. A private MIC that gates redemptions may ultimately allow cooler heads to prevail so that investors ultimately get do better in the long run. In any event, doing your homework prior to investing can go a long way towards avoiding things going wrong later.

Term to Maturity The shorter the duration of a MIC’s portfolio of loans, the less time for things to go wrong and less time for the value of real estate to decline enough for my equity to be at risk if it does. Many MICs focus on 1-to-2-year loans, although the average duration of loans may be even less than a year.

Public vs. Private. The typical pros and cons of public vs exempt market investments apply to the MIC world like they do public or private REITs. As I’ve mentioned the key issues earlier in this article, I won’t rehash them now. For those of you who have never purchased an exempt market investment, however, you will ultimately need to sign the standard acknowledgement that states that you know you could lose all of your money, regardless of its track record and downside protection. Strangely enough, there is no such requirement when purchasing a penny stock on the TSX.

Track Record, Management Team, etc. Like any investment, you’ll want to look at how long they have been in business, who is calling the shots, the company size, the continuity of their management team, whether they have missed any payments and ever gated redemptions.

Deal Flow and Growth. I like to know where a fund gets the majority of its clients and how quickly a MIC has grown. I also want assurances from MICs that have grown quickly that they aren’t scrapping the bottom of the borrower barrel simply in order to deploy funds. It’s actually a good sign to me if a fund refuses to accept new money from time to time if they don’t feel they can deploy it prudently, as this shows a responsible management team.

Average Credit Rating. Although this won’t tell the full story, it’s useful to know the average borrower’s credit rating and how this has changed over the life of the fund, particularly over the last few years if a MIC has been growing on steroids.

Default Rate and Loan Loss Provisions. How many mortgages are in default or trending in that direction, what is the fund’s typical default rate and what sort of default assumptions are baked into their projections when calculating their yearly distributions? A Portfolio Manager friend of mine has a personal favourite that has never had a single mortgage default in its 14 years of existence, although that doesn’t mean they shouldn’t continue to plan for the worst. A healthy MIC will have a low default rate well below the rate used for its forecasting. As different provinces and states have different foreclosure rules and timelines, knowing how things work in that MIC’s prowling grounds can give you an idea how long it will take to convert real estate into hard cash so the money can be reinvested.

Minimum Purchase and Qualification Criteria. For private MICs, some require at least a $5,000 initial purchase, while others may require significantly more. There are also restrictions on qualified investors, based largely on their income and / or net worth.Moreover, not all MICs have the same minimum investment limits. In some cases, investors may need a sizeable income or over $1m in investable assets, while others may be accessible for those with a lower income and over $400,000 in investable assets. Once more, although anyone can buy a penny stock and invest as much as their heart desires, not everyone is eligible to invest in a private MIC or allowed to invest as much as they would like.

Information Flow. For private MICs, determine how often they will provide you with information updates and what sort of information you might receive. Some provide monthly newsletters.

Variable or Fixed. MICs that only issue variable mortgages have been able to raise distributions in lockstep with increase in the Bank of Canada’s lending rate, which is also a great inflation hedge. One of my MICs with variable-only mortgages literally increased distributions within an hour of the B of C rate decisions on many occasions. Those with fixed rates aren’t as nimble but will likely be able to sustain rates for longer once the Bank of Canada changes direction. Accordingly, a fixed rate portfolio with a longer average loan duration might sustain higher rates longer if interest rates decline, assuming their borrowers meet their commitments.

Fees. Although distributions from MICs are net of fees and I have no problem with good people getting well compensated, I still want to know what I’m paying. Moreover, sometimes, the management fee doesn’t tell the whole story, as MICs also typically charge borrowers a loan origination fee. Some MICs pocket this themselves in addition to their ongoing percentage management fees while others share the revenue. Accordingly, sometimes the basic management fee doesn’t tell the whole story.

CHMC Insurance. Most MICs do not have their mortgages insured with the CMHC.

Timing of Payments. If you are looking or needing monthly cashflow, then funds with monthly distributions are likely the ones for you. If this isn’t as vital, there are other funds that pay less frequently, such as quarterly.

Conclusion

Although MICs have been around almost as long as we’ve been taxing capital gains, many investors have never heard of this particular acronym, let alone added it to their investment portfolio. Like all categories of investments, there are the good, bad and the ugly. If you’re looking for a higher yielding investment and are looking for alternatives to traditional options such as bonds and GICs, MICs might be worth a second look. And, if that second glance turns into a desire to invest, please be sure to ask the tough questions so that you ultimately end up with the MIC (or the basket of MICs) of your dreams.