July 22, 2012 Comments

Friday was a weak day on the markets. Bright spots included Toll Brothers, up 4.4% and Walmart up 1.0%.

Also Liquor stores N.A up 2.4% and now up 17% since it was added to this Site as a Buy on April 10. eBay was another winner on Friday up 2.0% and up a stunning 48% this year (However we had only rated it a Weak Buy / Hold). Although I have not updated the report I am very doubtful that we would rate it a Buy at this point.

I am currently looking at Bank of America and hope to update shortly. While it has risks it appears to offer compelling value. I may add to my position in it.

I looked closely at Canadian National Railway’s annual report and Q1 report. I like what I see. They will report Q2 very shortly and it should be a good report. This is a good long-term bet.

Interest rates continue to plummet to extraordinarily low levels.

When it comes to long term government bonds, I would not consider owning them. Yes, everyone who invested in these bonds in the past 30 years has made out well and generally saw capital gains. Bonds rise in value as interest rates fall.

I went into this in detail in one of my articles.

Mathematically a perpetual risk free bond can continue to precisely double in value each and everytime interest rates fall in half. The theoretical maximum value approaches infinity as interest rates (on perpetuals) approach zero. But for 30-year government bonds there is an upper limit to the capital gains.

Consider a 30-year government of Canada bond issues at $1000 at today’s 30-year yield of 2.25%. The total cash flows from this bond over $30 years will be ( a whopping) $22.50 per year in interest for 30 years totaling $675. Plus the original $1000 for a grand total of $1675. But this money will received on average some 24 years from now. (^75 in interest payments received on average in 15 years and $1000 received in 30 years).

If 30-year interest rates somehow fall all the way to zero, then yes there remains a big capital gain on this bond, theoretically as high as 67.5% if that interest rate plunge happened tomorrow. More realistically if the interest rate falls immediately to 2.0% the capital gain would be only 5.6%.

It’s hard to imagine that anyone would buy a 30-year bond today for the sake of getting back their $1000 in 30 years and collecting a measly $22.50 per year in interest. First it would take only a little bit of inflation to make this into an investment that destroys purchasing power. Second, it is hard to imagine that there are not better investm,ents available.

Holding long-term government bonds on the speculation that interest rates will continue to fall could work out. But it comes at the cost of holding an investment that could plunge in value if interest rates rise.

If the 2.25% rate goes swiftly back to 4.0%, this bond would suffer a 30% drop in value.

10-year government of Canada bonds currently yield 1.62%. Even if rates plunged now to 1.0% this bond would only gain 5.9%. Whereas if rates returned to a more normal 4.0% then the bond would suffer a 20% loss in capital value.

It boggles the mind to think that certain investors are voluntarily accepting these flea-sized yields. Pension funds and insurance companies may be virtually forced to invest in these. Banks might also do it. There becomes a certain institutional habit where all these big players continue to invest in an irrational fashion and justify it on the basis of habit and the fact that all the others are doing it. Retail investors are free to think more independently and should think long and hard before investing at these low yields.

I would sooner short these bonds than hold them. However shorting can be emotionally challenging and it is not something that most retail investors should even consider.

I don’t pretend to understand why interest rates are so incredibly low. One possible explanation is actually that there is a huge surplus of money available to be loaned and few borrowers. That does not exactly seem to be the case however. Another possibility is that governments have somehow been able to force the rate low by having their central banks, federal agencies and possibly convincing banks and pension funds to buy these despite the tiny yields. If that is the case I don’t know that it can last indefinitely. At some point lenders are likely to demand higher interest rates.