The David Miner Communiqué—Summer 2007

Summertime – The sunshine makes for a nice state of mind.

In June, Dorinda and I took a European holiday -- we visited London and Paris and took the Eurostar train via the Chunnel between the two cities. We spent time in the cities as well as in the British countryside for some R&R. The weekend we got back, we were dragon boat racing over at the Toronto Islands. Finally, the early Sunday morning practices paid off! Our team won medals in 3 of the 4 final races and much improvement was made from last year. I also ran Brampton’s inaugural “Run for the Rose” half-marathon in July. During the August long weekend, my two daughters, Amelia and Victoria, “chipped” in the annual Caribana parade in Toronto. (Their old man did, too, but did not look nearly as good in his Caribana costume!)

U.S. Sub-Prime Mortgage Market – a Brief Explanation

From 2001 to 2006, the U.S. real estate market saw steady price increase. Consumers, swayed by easy credit and aggressive lending practices, used the increasing value in their houses to put cash in their pockets (and spend heavily). Predictably, as initial teaser rates on mortgages expire and interest rates creep upward, monthly mortgage payments become unaffordable for many.

Mortgage delinquencies are on the rise in the United States and more houses are for sale, resulting in an overall decline in U.S. housing prices. Today, a house in the U.S. stands on the market an average of nine months before being sold. It is common practice called “securitization” to bundle mortgages together for sale to institutional investors and hedge funds. Obviously some of these bundled subprime securities have recently declined in value. We are pleased to report that direct risk to our clients in these securities is minimal to non-existent.

Market Volatility

In the latter part of the summer, we saw some market volatility. The media focus has been on the sub-prime market. Should we be worrying?

Simply, no. Here’s why.

1. We are dealing financial markets and not granite slabs. Fluctuation is normal. Even brief periods of higher fluctuation are normal. The sub-prime concern the U.S. has been a growing issue for months and years. The fact that media has focused attention now seems a bit silly. And let us not forget that while U.S. mortgage defaults are on the rise, we are still talking about a relatively small percentage of the market.
2. The last couple years have been strong for equity markets. Corrections are normal.
3. Major economies remain strong, corporate profitability remains intact, and interest rates are still historically low.

We understand worry only if:

1. Portfolios are overly concentrated.
2. Short-term money is invested in long-term markets.

We work to avoid these two situations, so we do not bother to worry.

Borrowing to Invest

After recent market volatility, many might wonder why we now present discussion of borrowing to invest. In part, if financial markets are now a little cheaper, what better time than during a “sale”? Furthermore, it is likely that interest rates will not increase much further in the foreseeable future and may be even decline, so the cost of borrowing appears to be within acceptable ranges.

Should I borrow to invest? The simple answer - many people should not. There are pluses and minuses that must be considered in every situation. Nevertheless, borrowing can substantially increase net worth in the long term and reduce income tax in the short-term – two compelling reasons to think about it.

In a nutshell, borrowing to invest gives you leverage (and borrowing to invest is often called “leveraging”). Let’s take the example of an investor who faithfully deposits $7,000 into an RSP every year. The investor immediately gets a tax deduction of $7,000. Assuming an average annual compound growth rate of 10% over ten years, the investor’s RSP would grow to approximately $112,000. Not bad!

On the other hand, if the same investor borrowed $100,000 at an annual borrowing cost of $7,000 (also tax deductible), the investment would grow to about $159,000 (after the loan was repaid at the end). In the latter example, the investor would be responsible for income taxes on portfolio income and capital gain as realized. In the former RSP example, the portfolio is sheltered from income tax while inside the RSP and is fully taxable as income when withdrawn.

If we were to look at a twenty year term, then the story looks even more interesting. The pure RSP strategy grows to $401,000 and the leverage approach grows to $573,000. A fine-tuned tax analysis has not been presented herein, but all things being equal, leveraging starts to look interesting. Wow – a dilemma! How to decide?

Fortunately, we can now BOTH leverage and take advantage of RSP contributions, a win-win with GREATER tax deductions and LOWER “carrying costs” than doing one or the other.

Here’s how:
Some of the larger mutual fund companies – Franklin Templeton, Fidelity, and AGF for example – offer “T Series” funds. These funds offer a pre-set distribution, say 8%. Much of that distribution is expected to be return of capital. These distributions may be paid directly to investors.

In our $100,000 example, an investor borrows $100,000 at a cost of $7,000 per year and receives a cash distribution of $8,000 per year. The investor then deposits the $8,000 to an RSP. While the $8,000 distribution, being largely return of capital, is not expected to be fully taxable, the $7,000 interest cost on the loan and the $8,000 RSP contribution are fully deductible against income, a total tax deduction of $15,000. Net after tax cost of both making an RSP contribution and paying the interest cost on a loan is much smaller than either the loan interest or the RSP contribution on its own.

For income earners that have the cash flow and the ability to carry some debt, this tax efficient strategy is worth considering.

Now the downside……

1. As we all know, financial markets do not go straight up. Be prepared for some years when markets decline. (i.e., think long term only).
2. Interest rates can fluctuate – sometimes higher causing the carrying cost on a loan to go up. (In this situation, the RSP contribution can be reduced to allow for higher loan interest cost. You can in this way maintain a level tax deductible cash outlay.)
3. Any leverage program requires an ongoing monthly interest obligation to a lender. RSP payments are voluntary, loan interest payments are not. If you change your mind and want to get out too soon, your loan outstanding may be greater than your investment value.
4. Any loan affects your Debt Service Ratio. If you may otherwise need more debt in the near future (e.g., new house mortgage, new car loan), be cautious about borrowing for investment.

Consumers commonly borrow to buy houses and cars and carry loans with interest that is not tax deductible. So borrowing to invest is “good debt” insofar as the interest costs are tax deductible.

If you are interested, talk to us. Everyone’s situation is different. If we feel that leveraging is not right for you, we shall tell you so and why. Nevertheless, if it is a good idea, we can help in the following ways:

1. Assist in ascertaining a level or limit that is right for you.
2. Help arrange loans with quality lenders. Loans can provide 100% financing with no margin call (i.e., the lender will not demand payment if markets decline). Interest rates are usually slightly higher than Prime.
3. Put together a professionally designed investment strategy on a no-load (i.e., noncommission) basis.

Mutual Fund performance includes changes in share value and reinvestment of all dividends but do not take into account sales, redemption, distribution of optional charges or income takes which may have reduced returns. Fees and expenses are associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Mutual funds are not insured by the Canada Deposit Insurance Corporation or any other deposit insurer and are not guaranteed.