InvestorsFriend Newsletter December 2, 2018
Bank Fees that Annoy (and that make banks vulnerable to disruption)
One bank fee that has always annoyed me is the high charges for converting currency.
I’m not talking about the extra 2% or so that they charge, over and above the wholesale exchange rate, when we Canadians go into a branch to get $500 or $1000 American cash or whatever for a vacation. In that case, I can see that the bank faces real costs to provide that service. Each branch has to keep paper American currency on hand and there are obviously human labour and building-related costs to providing this in-branch service. In any case, Canadians do not need to carry much paper American cash when vacationing in the U.S. and so if the 2% only amounts to $10 or $20, and is paid infrequently it is really not a big deal. The same applies even more so the other foreign currencies. The banks face real costs to supply us with paper Australian dollars or Euros.
The currency exchange fees that really annoy me are those that are imposed on electronic self-serve transactions. Foreign currency credit card purchases, debit card purchases and account transfers usually include these fees.
Almost every Canadian Visa and MasterCard (coincidentally?) imposes an extra 2.5% fee, over and above the wholesale currency exchange rate. The existence of this fee is disclosed in the terms and conditions of each credit card. Conveniently, for the banks, this added 2.5% is rolled in with the wholesale exchange rate so that consumers never see this charge separately on their monthly statements. Given the all-electronic nature of credit card payments, I am sure that this fee is virtually 100% profit for the banks and/or Visa/MasterCard. And, just to be sure that they collect it, the banks charge a similar amount or more on debit card purchases. In 2018 TD Bank boldly raised their fee on foreign currency debit card purchases from 2.5% to a 3.5% adder over and above the wholesale rate.
Most Canadians have no real choice but to use their credit card or debit card while on vacation. It would be risky to carry enough foreign currency to avoid the use of cards and in any case the banks make sure to charge a relatively similar adder when we obtain paper money.
Canadians traveling abroad are basically captive customers and sitting ducks for this charge.
Another version of this fee that annoys me and costs me money is that the banks also impose added fees when transferring cash between Canadian and foreign currency accounts. The big Canadian banks allow a single RRSP account to have a Canadian dollar”side” and an American dollar “side”. When I looked into the cost of transferring $30,000 from Canadian dollars to U.S. dollars, even within the same RRSP account, the added fee was 1.0% to 1.25%. That’s $300 to $325. The percentage fee was lower at 0.39% to 0.60% for transferring $100,000. But the fee in dollars was higher at $390 to $600. These added foreign currency fees are being charged on self-serve fully electronic transactions where the bank faces no direct incremental costs. I am simply not convinced that the banks face any costs or risks that would come even remotely close to justifying these added fees.
Another bank fee that recently had my blood pressure shooting higher was a $5.00 fee to cancel an interac transfer. At my bank I get “free” interac transfers because I have an “All inclusive Account”. I recently had to cancel an interac transaction because the recipient’s email address had changed. The cancellation could only be done on-line and is therefore a self-serve electronic transaction that imposes zero incremental cost on the bank. I found it to be outrageous to be charged $5.00 for this particularly given that I have a so-called All Inclusive Account. Upon complaining, the fee was promptly reversed.
My belief is that the banks charge these fees because we are basically captive customers. Customers don’t choose their bank or credit card based on which bank has the lowest foreign currency fees. In fact, they can’t given that all the banks tend to be similar. And we don’t choose our bank accounts on the basis of the cancellation fee for interac transfers.
Overall, I am firmly convinced that banks as well as Visa and MasterCard are very much taking advantage of customers when it comes to these added foreign currency transfer fees and other fees on electronic self-serve transactions. Someday soon this may come back to haunt the banks as online competitors come in to disrupt banking. As banking becomes more and more about electronic transactions, costs are dropping rapidly. So far, the traditional banks are turning the lower costs into higher profits. At some point banks are going to face a disruptive competitor. This could be like Sears meeting Amazon. Or Yellowcab meeting Uber. It might be fun to watch.
Meanwhile, as customers, I believe we should take every opportunity to complain loudly and bitterly and to the highest levels when we see fees that seem unjustified.
Quickly Investing in a Diversified Fashion
Investing a diversified fashion with allocations to cash, fixed income and equities as well as with wide geographic diversification is considered the safest approach in the long term.
Some new Vanguard Exchanged Traded Funds are designed to allow Canadian investors instantly to achieve that by buying just one fund. Conservative, Balanced and more aggressive options are available and trade on the Toronto Stock Exchange under the symbols VCNS, VBAL and VGRO. These funds feature very low management fees. They were described in our February 2018 newsletter.
For investors using exchange traded funds, I have recently updated our article that gives a selected list of global ETFs and comments on which ones look attractive. At this time many country ETFs are cheaper in relation to earnings than they were in previous updates going back several years. The China and South Korea ETFs look particularly attractive on a price to earnings ratio basis. Our Canadian ETF list will be updated in the next week or two.
How higher interest rates affect investment values:
It’s a mathematical fact that higher interest rates reduce the market prices of existing bonds, especially long-term bonds. And it is accepted wisdom that higher interest rates are also bad for stock prices. All else being equal, the higher that interest rates climb, the lower the price to earnings ratios on stocks. But why exactly is that? I’ll go through some of the math below. And, I’ll get into that “all else being equal” bit as well.
The most basic step in understanding how higher interest rates lower most investment values is to observe the simple mathematical fact that any sum of money that earns interest will grow faster if interest rates move higher. This then leads to the opposite mathematical fact that any given sum of cash to be received on a specific date in the future has a lower present value at higher interest rates. Higher interest rates are therefore a strong gravitational force on the value today of cash to be received in the future.
For example, if the applicable interest rate is 2.5% then the value today of $1000 to be received in ten years is (1000/1.025^10) = $781. That’s because $781 deposited at 2.5% interest will grow to $1,000 in ten years. So, since $781 today can be reliably turned into $1000 in ten years with no risk in a bank account, then $1000 to be received in ten years is worth only $781 today. But if the applicable interest rate rises to 4%, then the value of this future $1,000 falls to $676, for a decline of 13%. And if the interest rate rose dramatically to 10% then the value would fall dramatically to just $386, for a loss of 51%.
Note that even though the same $1,000 is to be received in ten years in all three cases, the present value or market value of that future $1,000 declines with higher interest. The market value declines become even larger the further into the future the cash is to be received.
So, clearly, the value of bonds that pay out fixed amounts of cash on specific dates must fall as interest rates rise. And stocks are also expected to pay out or be sold for cash at some point in the future. Therefore, all else being equal, higher interest rates are negative for stocks as well as bonds.
Interest are expected to continue to rise
The Bank of Canada has indicated that its policy rate, which in the past sixteen months has increased in five steps from 0.5% to 1.75%, will need to rise by a further 0.75% to 1.75%. That would take it to a neutral rate, estimated to be about 2.5% to 3.5%.
Since most investments produce cash flows over the long term, it is longer-term interest rates rather than the overnight Bank of Canada policy rate that most investments are sensitive to. Currently, the interest rate on the government of Canada 10-year bond rate is at 2.3%, which is 0.55% higher than the policy rate. Therefore, investors should probably expect, or at least be prepared for, the 10-year government bond rate to increase to about 3.05% to 4.05%.
While some investments are less sensitive to interest rates than others, the fact is that, as explained above, higher interest rates exert a gravity-like force on essentially all investments other than cash and near-cash investments. However, in some cases there are offsetting forces.
How to Position yourself for higher interest rates
This is highly dependent on each investor’s time horizon and risk tolerance. In general, most investors should respect the fact that the future is never certain and they should therefore continue to hold a balance of different asset classes.
The following describes the interest rate sensitivity of the main types of investment assets and provides comments on how to adjust your portfolio in these circumstances.
Cash. In an investment account, cash has no correlation to or immediate sensitivity to interest rates. Of course if the cash earns interest, it can grow over the longer term but the effect is not immediate.
Action: Cash, including high-interest savings accounts, often gets little respect due to its very low returns. However, experience teaches that there is no substitute for cash. Only cash is guaranteed to be there and to not have declined in value or to be locked in if you need it at a moment’s notice, either for spending or to pounce on an investment opportunity. Given these advantages and the interest-rate sensitivity of the other choices, it would seem wise to consider increasing cash holdings at this time.
GICs. If guaranteed investment certificates were traded, they would have some sensitivity to interest rates. But, because they are relatively short term and especially because they are not normally tradable or marked to market on your broker statement, GICs are considered to have no correlation or immediate sensitivity to interest rates.
Action: GICs also don’t get a lot of respect. But their stability and safety earns them a place in many portfolios. This is particularly true for non-taxable retirement accounts. A laddered approach is appropriate so that new cash is available to take advantage as rates rise.
Bonds. The market value of government bonds always falls with higher interest rates. There is a perfect negative correlation between government bond prices and higher interest rates. Nothing else affects the market value of a government bond. Therefore, government bonds can be said to be 100% interest rate sensitive. The longer their term in years, the more they fall in value as interest rates rise. By government bond here I refer to central governments that issue the currency in which the bond is denominated.
In the case of corporate bonds, their market value also falls with higher interest rates. But they do not have quite a 100% negative correlation with rates because their market value is also affected by changes in the credit rating and/or the financial strength of the issuer. That said, corporate bonds are still very highly interest rate sensitive.
Action: Bonds have the highest sensitivity to interest rates. Given the strong expectations that rates will rise, longer term bonds are probably best avoided or minimized at this time. A laddered approach seems sensible for shorter-term bonds.
Perpetual preferred shares. These have interest rate sensitivity similar to a very long-term corporate bond.
Action: Perpetual preferred shares should also be avoided or minimized. However, if they are being used to generate income for spending purposes, and if a lower market value is not of primary concern, then these remain appropriate.
Rate reset preferred shares. They are somewhat sensitive to changes in interest rates but that sensitivity is muted by the resetting of interest rates every five years and by the right of the issuer to repurchase the shares at par on each five-year anniversary.
Action: Rate reset preferred shares are generally expected (although not guaranteed) to largely retain their values, as interest rates rise, or to return to par value at their reset dates. Therefore, an increased allocation to these might be appropriate. Issues that are trading below $25 but which have not suffered a deterioration in their credit rating and which will reset in the next twelve to twenty four months should do well. However, this is not guaranteed and these shares can fall in value due to changes in their perceived attractiveness unrelated to interest rate changes.
High dividend, low-growth stocks. These have cash flows that are reasonably predictable. Higher interest rates act to reduce the present market value of those expected future cash flows, just as they do any future cash flow. But their values are also affected by changes in the credit rating and/or financial strength of the issuer as well as, importantly, by changes in estimates of the future growth (or decline) of the dividend and earnings. As a result, these stocks are interest rate sensitive but the correlation and sensitivity is not as strong as that of bonds or perpetual preferred shares.
Action: These stocks are interest sensitive and therefore a somewhat reduced allocation seems appropriate unless they are held primarily to generate needed cash.
Non- or low-dividend high-growth stocks. Their value is primarily linked to changes in estimates of the growth in earnings per share. Future growth in earnings could be lowered by the effect of higher interest rates on company debt. However, conversely, higher interest rates could be associated with an improving economy, leading to higher earnings. The share value also depends on the credit rating and financial strength of the issuer. All else being equal, the value of these stocks is also negatively correlated with higher interest rates. However, because in these cases there are many factors that are not likely to remain equal as interest rates change, the negative correlation with interest rates can be very weak. Therefore, these stocks are generally not considered to be interest rate sensitive.
Action: These stocks are less interest rate sensitive. Nevertheless, they are not immune to the gravitational effect of higher interest rates. It might be appropriate to maintain but not increase the allocation to these. Exceptions would include stocks that are expected to have particularly strong earnings growth but where the price is not already fully reflecting the expected growth.
An ideal investment at this time, with interest rates expected to rise, would be one that is expected to increase in value with higher interest rates. One such possibility would be to “short” long-term bonds. But that would be pure speculation and is certainly not advisable for most people. Bank shares could benefit from higher interest rates as non-interest chequing account money is loaned out at higher rates. However, their mortgage business may slow and they could be hit with more bad loans in a higher rate environment.
Overall, with higher interest rates exerting an undeniable gravitational force on the value of all future cash flows, there are no investments (setting aside shorting strategies) that are guaranteed to increase in the short term if interest rates rise.
In the longer term, however, higher interest rates provide the opportunity to invest cash, including new contributions, maturing bonds, dividends, and interest coupons, at higher rates and lower price earnings ratios. This would lead to higher returns in the future. Perhaps the best available approach is to plan to have additional cash to invest if interest rates do in fact rise.
December 2, 2018
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