In this issue:

Next Update Edition: August 15

Next regular issue: August 29

ADAPTING TO INTEREST RATES

By Tom Slee, Contributing Editor

Quantitative easing is history – at least as far as most investors are concerned. Federal Reserve chairman Ben Bernanke plans to extend his bond-buying program into 2014 but the markets are already moving on. A lot of the adjustment has taken place. Stocks plunged when the news was announced and have remained weak ever since. Short- and long-term interest rates, already moving higher in May, spiked because they had been artificially suppressed. REITs dropped sharply in value. People were buying them for income rather than growth so they had become sort of surrogate bonds. Preferred shares sold off along with other fixed income securities.

Apart from the weird stock market correction, most of that turmoil had been anticipated. Here at Income Investor, several times we pointed out an increasing upward pressure on interest rates. We have had a tug of war in North American bond markets since the beginning of the year. A burgeoning economy was pushing rates up and the Fed’s traders were struggling to keep a lid on them. As a result, there was a head of steam. When the central bank finally decided to step aside, it blew. Ten-year Government of Canada bond yields jumped almost 75 basis points to about 2.45% during May and June. Rates now have an upward bias.

We need to adapt. Bond prices are no longer going to move sideways month after month. There is going to be increased volatility as rates rise and fixed income securities decline in value. However, the real changes are likely to be gradual, a two- step-forward one-step-back process. I doubt very much whether we will see another surge in rates. The recovery is still too weak to drive bond prices sharply one way or the other. In any event, the Fed will continue to dampen movement. It is certainly going to protect 30-year U.S. mortgage rates. These have moved up 60 basis points. Any further increase at this stage would undo five years of quantitative easing.

My feeling, therefore, is interest rates will tend to remain around their present levels for a while and then only gradually trend higher. Tune out all the media talk about an entirely new playing field. Bond markets usually move at glacial speed, which is why the recent turmoil has created so much comment. I expect them to become more orderly and hopefully a little more predictable. Here is the movement we are likely to see over the next year or so.

Given the current rate of economic growth, 30-year Government of Canada bonds, now yielding about 2.9%, could be paying almost 4% by the end of 2014. This is an important benchmark because to some extent it dictates commercial mortgage rates. Medium-term interest rates are also expected to rise and by the start of 2015 10-year bond yields are likely to be in the 3.5% range, up 100 basis points, from the present 2.5%. The crucial five year issues should pay close to 3% by that time. At present they yield 1.8%. The Bank of Canada overnight rate, currently 1%, is likely to be 1.5%.

In the United States, now that investors have come to terms with the Fed’s departure, five-year yields, now close to 1.4%, are expected to climb to about 2.15% at the end of 2014. Longer term, 30-year issues should yield almost 4.5% by that time. At present they pay 3.5%. In the very short end, however, there may be little or no change over the next 18 months. Forecasters think that the Fed will maintain control on this part of the market and three-month treasury bills could still be paying their present 0.05% by the end of 2014.

Keep in mind these are just projections and the numbers are not nearly as precise as they seem. For some reason, bond market forecasters deal in two places of decimals. The truth is interest rates rarely move in unison and they are just as hard to predict as stock markets.

That being said, everything points to interest rates trending higher across the board. The progress, though, is likely to be uneven and occasionally reversed. There is going to be the odd panic. As a matter of fact, I am concerned about two problems created by the jump in interest rates. They could disrupt prices and cause the Fed to intervene.

Number one, fixed income markets are global and Mr. Bernanke’s decision to withdraw his stimulus created a serious ripple effect in Europe. It seems several of the countries that were recently bailed out, such as Greece, are living on a knife’s edge. Even a slight increase in interest rates could trigger another crisis. In that event, we would see a flood of institutional money into North American bonds. The buying is bound to drive up prices and leave us with record-low interest rates again.

A second danger has been created by new legislation aimed at helping investors. Figures from the Bank of America showed that global bond fund redemptions totalled a record US$23 billion during June. Wall Street dealers were also bailing out. Their corporate bond inventories fell 15%. Normally investment banks would scoop up this outflow for eventual distribution into retail accounts. Because of revised capital adequacy rules however, there is no longer any profit for the banks in this business. They have withdrawn their bids. We have lost a buffer. Bond markets are going to become more volatile. Because of this reduced liquidity, bond funds are being forced to sell their best quality assets. Their remaining portfolios are much lower quality.

How do we respond to all of this? My feeling is we have seen the surge in interest rates. From now on, the upward trend is likely to be gradual. As a result, bonds are still relatively unattractive for investors seeking income. Bond funds, which depend on trading profits for their performance, are going to struggle in the new bear market.

So at the risk of sounding like a broken record, I think small investors should keep their bond commitments to a minimum and stay with government issues of five-year term or less. That way, you can earn an unexciting but acceptable return and know that your capital is safe. For example, as I write, the Province of Alberta 5.03% bonds due 2018 are trading at $109.80 and yield 3.07%. You are also positioned to reinvest when yields are likely to be more attractive. Avoid long-term issues because they are going to drop in value as rates rise. Steer clear of high yield (junk) bonds. They are too expensive vis-à-vis investment grade debt.

Preferred shares are still a much better bet for income. However, I would sacrifice a little yield and avoid straight (perpetual) shares. Opt instead for issues with a reset provision a few years out. The BCE First Preferred Shares Series 5 (TSX: BCE.PR.S) on our Buy list fit the bill. Trading at $23.80, they pay a $0.75 annual dividend and yield 3.2%, equal to about 4.5% from a bond in an unregistered account after adjustment for the dividend tax credit. They have what is essentially a reset provision on Nov. 1, 2016. You will then be able to benefit from any interest rate increase during the next three years.

REITs have been oversold and some of them now represent excellent value. Flagship RioCan (TSX: REI.UN) dropped 14%. That spells “buying opportunity.” Crombie (TSX: CRR.UN), which we recently recommended as a Sell at $15.80 to take a 35% capital gain, is now very attractive at $13.35. With a solid $0.89 annual distribution, the units yield 6.6%. The big news is Empire Company, Crombie’s parent, has acquired Canada Safeway for $5.8 billion. The deal creates an opportunity for Crombie to buy associated prime real estate for $1 billion. This would be a transformational acquisition for the REIT. I will update Crombie when more details emerge but right now it is reinstated as a Buy for income and growth. Here at Income Investor, we do not set targets but Bay Street expects to see the units at $16 despite the sector being out of favour.

Tom Slee managed millions of dollars in pension money during his career and is an expert in fixed income securities.

 

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THE DEAL WITH CORPORATE REITS

By Tom Slee, Contributing Editor

A reader recently asked us to explain why markets have been responding favourably to major corporations spinning off their real estate into publicly traded REITs. At first glance, it looks as though the corporations are just shuffling assets. Yet in every case the stocks have jumped in value.

There are several big advantages in launching a REIT. First and foremost, it unlocks value. Many companies such as retailers and banks are sitting on vast properties, steadily increasing in value, which are never reflected in the stock market. These days, analysts and investors are focused on earnings, not balance sheet items and for good reason. Balance sheets are suspect and sometimes misleading. For example, assets are usually shown at historical cost and lumped together. There is no indication of their potential and it’s usually difficult to get this information. So hardly anybody uses book value (total assets, less liabilities, divided by the number of common shares outstanding) when valuing a stock. As a result many of the more mature corporations are really undervalued.

Recently Loblaw and now Canadian Tire solved this problem. Both have announced creation of REITs that will hold most of their properties valued at today’s prices. They intend to retain most of the units but offer sufficient public distribution to provide the companies with a huge injection of new capital for new acquisitions. At the same time, they are diversifying into the lucrative property business and this will eventually bolster earnings. The Canadian Tire spinoff is a good example of how the process works.

In May, Canadian Tire announced its intention to create a $3.5 billion REIT to initially hold properties totalling 18 million square feet. The company will retain 80% to 90% ownership in the REIT. As a result, the company is going to receive a capital injection of approximately $500 million for expansion and acquisitions without incurring new debt or diluting equity with a stock issue. It intends to expand its REIT through outside opportunities and nearly all of these profits will flow to the parent and lift corporate earnings.

Despite mediocre earnings, Canadian Tire’s stock promptly jumped 11.2% or $8.32 to $82.36 when the announcement was made. Analysts, now able to value at least some of the major assets, started to use net asset value to assess the shares. Targets were raised from the $80 level to $95 or more. Given that reception, we may see other companies decide to unlock their intrinsic values.

 

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JULY?S TOP PICK

Here is our Top Pick for this month. Prices are as of close of trading on July 22 unless otherwise indicated.

iShares S&P Global Water Index Fund (TSX: CWW)

Type: Exchange-traded fund
Trading symbol: CWW
Exchange: TSX
Current price: $19.65
Entry level: Current price
Annual payout: $0.44
Yield: 2.2%
Risk rating: Moderate risk
Recommended by: Gavin Graham
Website: http://ca.ishares.com

The business: The water industry is a US$500 billion business, growing at 7% per annum or twice the rate of global GDP growth. This is driven by the ubiquitous nature of its product (everyone needs water to live) and the urbanization of the middle class in emerging markets. As the latter move from the countryside to cities and begin to live in modern buildings, they will demand access to safe, unpolluted and readily available water supplies for drinking, hygiene and sewage disposal. There’s also the legacy of underinvestment in aging water and sewage systems in the developed world. As the world continues to grow, it produces higher levels of waste and pollution. Investment in cleaner, more efficient resource use, such as filtration systems, power-efficient pumps, metering systems, inspection and replacement technology for pipes and networks and desalination are vital and crucial to success in the water industries.

The security: Formerly one of the Claymore sector funds launched six years ago, CWW was retained by iShares after its takeover of Claymore last year. CWW holds 50 stocks listed in developed and major emerging markets, equally divided between water utilities and infrastructure and water equipment and materials, such as pumps, valves, filters, pollution control equipment and disinfecting chemicals. Investments include both small and large-cap stocks. CWW’s largest holding (at 7.1%) is in Pentair (NYSE: PNR), a U.S.-based company that produces pipes, valves and filtration equipment. Other water equipment companies among its top 10 holdings include Swiss-based Gerberit (5.8%), U.S.-based Danaher (5.8%) and Swedish group Alfa Laval (4%). Capital goods comprise 42.5% of the fund, while utilities make up another 27% and materials 5.6%.

Why we like it: CWW has shown annual dividend growth of 7.6% over the last five years. Water utilities are generally able to grow their dividends with a fair degree of confidence since they are almost always regulated and permitted to raise their prices by some formula (usually inflation minus 2% to 4% per annum). This encourages the water industry to invest in their infrastructure and earn a real return while promoting efficiencies.

Financial highlights: CWW has achieved a 5% total return compounded over the last five years and 26% over the last 12 months, compared to -0.3% and 11.5% over the same periods for the TSX 60. This makes it a good and less volatile alternative to the Canadian index and to the current bond markets.

Risks: CWW only has $30 million in assets under management. That said, it has a long enough track record and a reasonable 0.67% management expense ratio to make it worth considering.

Distribution policy: Distributions are a bit inconsistent for this ETF. CWW paid distributions of $0.065 a quarter for the first three quarters of 2011 but upped that to $0.09 in December 2011 for a total of $0.27. In 2012, CWW then paid $0.042, $0.05 and $0.06 for the first three quarters before paying $0.26 in December, for an annual total of $0.41. So far this year, CWW has paid two quarterly distributions of $0.061. The payout and yield shown above is based on the trailing 12-month distributions.

Tax implications: Distributions from this ETF are treated mainly as fully taxable foreign income. You may wish to hold the units in a registered plan to avoid this. Any profit or loss on sale or redemption is treated as a capital gain or loss at the time if the units are in a non-registered account.

Who it’s for: This is suitable for investors who are looking for income that will be reasonably resilient in the face of monetary tightening. Utilities have proved to be an attractive target for pension funds, given their relatively high yields, the long-life nature of their assets and the inflation-protected charging structure permitted by governments.

How to buy: These securities are listed on the TSX and available through any broker or dealer.

Summing up: CWW is a more defensive means of providing some reasonable income with a degree of inflation protection.

Action now: Buy at $19.65. – G.G.

 

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JULY UPDATES

Here are this month’s updates. Prices are as of the close of trading on July 22 unless otherwise indicated.

Enerplus Corp. (TSX, NYSE: ERF)

Type: Common stock
Trading symbol: ERF
Exchange: TSX, NYSE
Current price: C$17.07, US$16.49
Originally recommended: Dec. 19/12 at C$12.62, US$12.82
Annual payout: $1.08
Yield: 6.3%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.enerplus.com

Comments: When I last reviewed Enerplus in May, I changed my recommendation to Hold because of the price increase of almost 30% since the original recommendation last December. Since then, we’ve seen a small uptick in the price but nothing significant, confirming my view that the shares are fairly valued at this level.

In recent news, the company announced in late June that it is selling some of its non-core assets for $80 million. They are described as “non-operated properties producing approximately 1,000 boe/day (barrels of oil equivalent per day), of which roughly 90% is weighted to crude oil and natural gas liquids. The properties are being sold to multiple parties.” Enerplus expects the deals to close during the current quarter.

Some of that money ($30 million) is being used to acquire an incremental 50% working interest in the Pouce Coupe South Boundary B Unit #1. Enerplus is the operator of this property and now has an approximate 100% working interest. The additional interest in this light oil waterflood property produces approximately 375 boe/day and has a low historical decline rate of roughly 5%. The property has an average netback of approximately $50/boe.

Year-to-date, Enerplus has sold or has agreements to sell $115 million in non-core assets. Despite this, the company is maintaining its production guidance for 2013 at about 85,000 boe/day.

The shares pay $0.09 a month ($1.08 per year) to yield 6.3% at the current price.

Action now: Hold. – G.P.

Bissett Canadian High Dividend Fund (TML205)

Type: Mutual fund
Code: TML205
Current price: $15.72
Originally recommended: July 27/11 at $15.58
Annual payout: $0.74
Yield: 4.71%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.franklintempleton.ca

Comments: This fund hasn’t provided much in the way of capital appreciation but it has been a steady cash producer in the two years since I recommended it. The portfolio focuses on small to mid-cap stocks and includes a number of former income trusts, which have converted to corporations but still offer above-average yields. These include Medical Facilities Corp., New Flyer Industries, Morneau Shepell, Freehold Royalties and Crescent Point Energy. Several of the names will be familiar to readers as current or past recommendations of this newsletter.

The basis distribution is $0.055 a month but every third month this is increased to $0.075 per unit, for a total of $0.74 per year. In addition, there may be a year-end capital gains distribution, which was $0.415 per unit in 2012. Some of the distributions are tax-advantaged; last year 36% of the payment was treated as a capital gain, 11% was return of capital, and the rest was classified as full-taxable interest, according to Morningstar. Interestingly, none of the distribution was considered to be dividends, despite the name of the fund.

The fund is performing well thus far in 2013 with a year-to-date gain of 10.3% to July 22. Its track record over the past decade is excellent, beating the category average in all time frames.

Action now: Buy. Note that this fund is only suitable for investors who can tolerate above-average risk. – G.P.

BMO Monthly Dividend Fund (GGF588)

Type: Mutual fund
Code: GGF588
Current price: $9.32
Originally recommended: Oct. 23/03 at $8.90
Annual payout: $0.42
Yield: 4.5%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.bmo.com/home/personal/banking/investments/mutual-funds/funds

Comments: This fund was originally part of the Guardian family but owner BMO dropped the name earlier this year and folded the fund into its Advisor series. The management team remains the same, however.

The fund has been a credible performer over time but lately its results have slipped in comparison with the peer group. The fund had a one-year gain of 6.1% to June 30 and is only up about 2% so far in 2013.

The portfolio is a mix of high-yield common stocks such as Shaw Communications and preferred shares from leading companies. The preferred share content was a plus when interest rates were low but it adds more risk during a time when rates are expected to rise.

There are better choices now available for investors who want income-oriented mutual funds so I suggest cashing in your units and moving on. If you want to invest in something similar, try the CI Signature Dividend Fund, updated below.

Action now: Sell. – G.P.

CI Signature Dividend Fund (CIG610)

Type: Mutual fund
Code: CIG610
Current price: $13.24
Originally recommended: Sept. 17/04 at $12.69
Annual payout: $0.48
Yield: 3.63%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.cifunds.com

Comments: This fund follows a similar mandate to that of the BMO fund, investing in a mix of blue-chip stocks and preferred shares. The difference is that this fund does it better. It has been an above-average performer over all time frames from three months to 10 years while providing steady monthly cash flow, currently $0.04 per unit. The management team is led by Eric Bushell, who is one of the best in the business.

This fund offers a global portfolio. About half the assets are in Canada with 22% in U.S. securities, 16.7% in Europe and the rest spread around. Risk is on the low side for a fund of this type but don’t lose sight of the fact it’s an equity portfolio. If the stock market crashes, this fund will be hit as it was in 2008 when it dropped 26%. The large position in preferred shares could also be vulnerable when interest rates rise.

That said, the fund has been a strong performer so far in 2013 with a year-to-date gain of just over 9%. It remains a good choice for investors who want a combination of cash flow, relatively low risk, and modest growth potential.

Action now: Buy. – G.P.

Phillips, Hager & North High Yield Bond Fund (PHN280)

Type: Mutual fund
Code: PHN280
Current price: $12.12
Originally recommended: June 24/03 at $10.87
Annual payout: $0.60
Yield: 4.95%
Risk Rating: Moderate risk
Recommended by: Eric Kirzner
Updated by: Gordon Pape
Website: www.phn.com

Comments: All bond funds are vulnerable when interest rates rise but high-yield funds often fare better than those that invest in conventional debt securities. Plus, this is one of the lowest risk funds of its type, which makes it even more important to hang on to your units if you are lucky enough to own any. (The fund is closed to new investors although current unitholders can add to positions.)

The fund invests in an international portfolio of high-yield corporate bonds, mainly in the U.S. (55%) and Canada (40%). Most of the assets fall into the “junk bond” category, with 70% of the portfolio rated BB or lower. Despite this, the fund has an enviable safety record; the worst loss in any 12-month period was 3.75% in the year to Oct. 31, 2008.

Over the year to June 30, the fund generated a return of 6.3%. The average annual compound rate of return in the decade since we originally recommended it was 7.8% so this is a class buy-and-hold fund for the fixed-income section of a portfolio.

Distributions are currently being paid at a rate of $0.15 per quarter or $0.60 annually. There may also be a bonus capital gains distribution at year-end; in 2012 it was $0.144 per unit. The MER is a very reasonable 0.89%.

Action now: Hold. – G.P.

Phillips, Hager & North Short Term Bond and Mortgage Fund (PHN280)

Type: Mutual fund
Code: PHN250
Current price: $10.43
Originally recommended: May 26/04 at $10.14
Annual payout: $0.24
Yield: 2.3%
Risk Rating: Conservative
Recommended by: Gordon Pape
Website: www.phn.com

Comments: It is possible to lose money on this fund if interest rates go the wrong way, but it’s not likely to happen and if it does the loss will be small. The worst 12 months in its history was a decline of just over 2% in the year to Jan. 31, 1995, almost two decades ago. The fund has not had a year of red ink in many years.

The portfolio is a mix of high-quality government and corporate bonds (rated BBB or better), CMHC and conventional mortgages, and cash (18.4% of total assets). It’s about as low-risk a bond portfolio as you’ll find with a duration of 2.3 years. Even at that, it lost 0.57% during June.

You won’t get rich with this type of fund. The objective is to protect capital and to generate a modest return, which this fund does very well. Over the past five years, the average annual compound rate of return was 3.8% but don’t expect anything approaching that in 2013. The year-to-date gain is just 0.75% so for the full year look for a return of between 1.25% and 1.5%.

The MER is only 0.61%, very low for a mutual fund of this high quality.

Action now: Hold. – G.P.

Phillips, Hager & North Total Return Bond Fund (PHN340)

Type: Mutual fund
Code: PHN340
Current price: $11.43
Originally recommended: Jan. 21/09 at $10.59
Annual payout: $0.36
Yield: 3.4%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.phn.com

Comments: There’s more risk here than in the Short Term Bond and Mortgage Fund but greater return potential as well. Over the three years to June 30, the fund posted an average annual compound rate of return of 4.3%, almost a full percentage point higher than the category average. Recently, it’s been a struggle for the managers, however. The fund gained only 0.37% in the latest 12 months and is in the red by 0.73% so far this year. That’s not a disaster, of course, but it’s a foretaste of what to expect as rates rise.

The fund invests primarily in high-rated Canadian bonds, with about 56% of the assets rated AAA or AA. The management team can also invest in foreign and high-yield bonds but right now those positions are negligible.

I regard this as a core fixed-income fund but the reality is that we’re unlikely to see any significant gains for some time and may even experience some small losses. However, the managers have shown an ability to minimize the downside risk; the worst period in the fund’s history was a decline of 0.76% over the year ending Feb. 28/09.

Action now: Hold. If you want to reduce risk, move some of the assets to the Short Term Bond and Mortgage Fund. – G.P.

RBC Canadian Equity Income Fund (RBF591)

Type: Mutual fund
Code: RBF591
Current price: $24.89
Originally recommended: Dec. 9/09 at $19.19
Annual payout: $1.08
Yield: 4.34%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: http://funds.rbcgam.com/

Comments: I originally recommended this fund for a combination of cash flow and growth potential and it has delivered on both counts. At the time I advised buying, the fund was paying monthly distributions of $0.0625 per unit or $0.75 a year to yield 3.91%. Now the monthly payment is up to $0.09 a unit ($1.08 a year). So even though we have had a price appreciation of $5.70, the yield is actually higher today. If you bought at the time of the original recommendation, the yield on your cost price is 5.63%.

Not only that, the fund has managed to significantly improve its net asset value over the past year despite the higher payout. That’s the kind of performance we like to see.

The portfolio invests primarily in Canadian stocks (80.7%) with a small position (10.8%) in the U.S. equity market. The focus is on large cap stocks which is a sea change from the original style which focused more on income trusts and companies that had converted from trust status. It’s clear from the results that managers Brahm Spilfogel and Jennifer McClelland have handled the transition well; the fund shows a three-year average annual compound rate of return of 15.6% and has gained 7.6% thus far in 2013.

Action now: Buy. This fund has done everything we expected, and more. – G.P.

Chemtrade Logistics Income Fund (TSX: CHE.UN, OTC: CGIFF)

Type: Income trust
Trading symbol: CHE.UN, CGIFF
Exchange: TSX, Grey Market
Current price: C$17.07, US$16.49
Originally recommended: Dec. 21/11 at C$14.08, US$13.56
Annual payout: $1.20
Yield: 6.9%
Risk Rating: Higher risk
Recommended by: Tom Slee
Website: www.chemtradelogistics.com

Comments: Chemtrade, a leading marketer of sulphuric acid, liquid sulphur and ultra pure acid, continues to make solid progress. The first quarter 2013 operating profit of $38.6 million was in line with consensus forecast and the company is on track to earn distributable cash of $1.65 a unit in 2013. Analysts expect an increase to about $1.95 in 2014. That means the current $1.20 distribution represents conservative payout ratios of 73% and 62% respectively.

The trust continues to negotiate risk-sharing contracts to protect its cash flow. International sulphuric acid markets have weakened recently but Chemtrade’s pulp margins are stable. Excess cash flow is being used to reduce debt. The distributions are sustainable. It currently yields 6.9%.

Action now: Buy. – T.S.

 

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YOUR QUESTIONS ANSWERED

PIMCO Monthly Income Fund

Q – I am looking at the PIMCO Monthly Income Fund and am considering investing in it. Can you explain how it has done so well for a fund that is advertised to be low risk and would you recommend it? – Ken L.

A – There’s no question the fund has been impressive since it was launched in January 2011. It gained almost 16% over the year ending June 30 and was showing a two-year average annual compound rate of return of 15.1% at that point. But don’t be blinded by those numbers. As of the close of trading on July 19, the fund was only showing a 3.3% year-to-date advance and was down 0.6% over the previous 30 days. In other words, it’s running out of steam.

It’s not hard to understand why. The fund invests in a portfolio of foreign bonds and mortgages, primarily denominated in other currencies. The bond market remained strong in 2011 and 2012 as yields declined in the face of a slow-growth global economy. This year we have seen commercial rates starting to inch higher, even though central banks continue to hold the line. Rising rates are bad news for fixed-income investments because as yields move higher, prices decline.

PIMCO, which is based in southern California, is one of the most respected fixed-income traders in the world. But even it cannot hold back the tide although through astute security selection, its managers can mitigate losses. One of the ways they achieve this is by shortening the average term of the securities in the portfolio; as of June 30, the fund’s duration was only 4.4 years. (Duration is a measure of a fund’s sensitivity to interest rates; the higher the duration the greater the risk. The DEX Universe Bond Index has a duration of about six, so this fund has below average rate sensitivity.)

The fund pays monthly distributions which have generally run between $0.04 and $0.05. Over the year to June 28, it paid out $0.6127 per unit, which works out to a trailing yield of 4.4% based on the July 19 net asset value of $14.02. The price over that period increased by $1.37 which is a very healthy sign.

This is a first-rate fund if you are looking for exposure to the international bond market, top-quality management, and a decent yield. My main concern is the negative effect of rising interest rates on the return. That said, the year-to-date return is comfortably positive and puts this fund among the best performers in its category so far in 2013. – G.P.

Enervest Diversified Income Trust

Q – I would like to know if the Enervest Diversified Income Trust is a good investment. It is trading at $11.69 (July 19) but the net asset value is $13.57. Annually the company allows redemption at 95% of NAV. The holdings are blue-chip Canadian stocks and good quality bonds and debentures. In 2012, 65% of the distribution ($0.10 monthly) was return of capital and 35% taxable dividends. – Max V., Vancouver

A – Enervest is a $1.1 billion closed-end fund that trades on the TSX. Such funds normally trade at a discount to NAV so the price differential is not unusual. About two-thirds of the portfolio is in Canadian equities with stocks such as Royal Bank, Scotiabank, Suncor Energy and Canadian Natural Resources topping the list. Of the remaining assets, 16.5% are in U.S. stocks, 3% in international equities, 12.3% in bonds and 4.3% in cash.

According to the company’s own website, recent performance has lagged the benchmark which is the S&P/TSX Total Return Index. The fund posted a gain of 8% over the 12 months to May 31 compared to 13.3% for the benchmark and showed an average annual loss of 1.9% over two years. Taking the longer view, the fund just about matched the TSX over the past decade with an average annual gain of 9.2% compared to 9.1% for the index.

Distributions have remained steady at $0.10 a month since 2010, which works out to a very attractive yield of 10.3% based on the current market price. However, both the NAV and the market price have declined over that time some investors have given back some of their cash flow in the form of a loss of equity.

Although we have recommended a few closed-end funds over the years, none has ever turned out to be an outstanding performer. Enervest appears to be no exception. If you like the cash flow, go ahead and invest but be prepared for the possibility of a gradual decline in market value over time, in part due to the relatively high management expense ratio of 1.73%. – G.P.

 

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That’s all for this issue. Look for your next Update Edition on Aug. 15. The next regular issue will be published on Aug. 29.

Best regards,
Gordon Pape, editor-in-chief

In this issue:

Next Update Edition: August 15

Next regular issue: August 29

ADAPTING TO INTEREST RATES

By Tom Slee, Contributing Editor

Quantitative easing is history – at least as far as most investors are concerned. Federal Reserve chairman Ben Bernanke plans to extend his bond-buying program into 2014 but the markets are already moving on. A lot of the adjustment has taken place. Stocks plunged when the news was announced and have remained weak ever since. Short- and long-term interest rates, already moving higher in May, spiked because they had been artificially suppressed. REITs dropped sharply in value. People were buying them for income rather than growth so they had become sort of surrogate bonds. Preferred shares sold off along with other fixed income securities.

Apart from the weird stock market correction, most of that turmoil had been anticipated. Here at Income Investor, several times we pointed out an increasing upward pressure on interest rates. We have had a tug of war in North American bond markets since the beginning of the year. A burgeoning economy was pushing rates up and the Fed’s traders were struggling to keep a lid on them. As a result, there was a head of steam. When the central bank finally decided to step aside, it blew. Ten-year Government of Canada bond yields jumped almost 75 basis points to about 2.45% during May and June. Rates now have an upward bias.

We need to adapt. Bond prices are no longer going to move sideways month after month. There is going to be increased volatility as rates rise and fixed income securities decline in value. However, the real changes are likely to be gradual, a two- step-forward one-step-back process. I doubt very much whether we will see another surge in rates. The recovery is still too weak to drive bond prices sharply one way or the other. In any event, the Fed will continue to dampen movement. It is certainly going to protect 30-year U.S. mortgage rates. These have moved up 60 basis points. Any further increase at this stage would undo five years of quantitative easing.

My feeling, therefore, is interest rates will tend to remain around their present levels for a while and then only gradually trend higher. Tune out all the media talk about an entirely new playing field. Bond markets usually move at glacial speed, which is why the recent turmoil has created so much comment. I expect them to become more orderly and hopefully a little more predictable. Here is the movement we are likely to see over the next year or so.

Given the current rate of economic growth, 30-year Government of Canada bonds, now yielding about 2.9%, could be paying almost 4% by the end of 2014. This is an important benchmark because to some extent it dictates commercial mortgage rates. Medium-term interest rates are also expected to rise and by the start of 2015 10-year bond yields are likely to be in the 3.5% range, up 100 basis points, from the present 2.5%. The crucial five year issues should pay close to 3% by that time. At present they yield 1.8%. The Bank of Canada overnight rate, currently 1%, is likely to be 1.5%.

In the United States, now that investors have come to terms with the Fed’s departure, five-year yields, now close to 1.4%, are expected to climb to about 2.15% at the end of 2014. Longer term, 30-year issues should yield almost 4.5% by that time. At present they pay 3.5%. In the very short end, however, there may be little or no change over the next 18 months. Forecasters think that the Fed will maintain control on this part of the market and three-month treasury bills could still be paying their present 0.05% by the end of 2014.

Keep in mind these are just projections and the numbers are not nearly as precise as they seem. For some reason, bond market forecasters deal in two places of decimals. The truth is interest rates rarely move in unison and they are just as hard to predict as stock markets.

That being said, everything points to interest rates trending higher across the board. The progress, though, is likely to be uneven and occasionally reversed. There is going to be the odd panic. As a matter of fact, I am concerned about two problems created by the jump in interest rates. They could disrupt prices and cause the Fed to intervene.

Number one, fixed income markets are global and Mr. Bernanke’s decision to withdraw his stimulus created a serious ripple effect in Europe. It seems several of the countries that were recently bailed out, such as Greece, are living on a knife’s edge. Even a slight increase in interest rates could trigger another crisis. In that event, we would see a flood of institutional money into North American bonds. The buying is bound to drive up prices and leave us with record-low interest rates again.

A second danger has been created by new legislation aimed at helping investors. Figures from the Bank of America showed that global bond fund redemptions totalled a record US$23 billion during June. Wall Street dealers were also bailing out. Their corporate bond inventories fell 15%. Normally investment banks would scoop up this outflow for eventual distribution into retail accounts. Because of revised capital adequacy rules however, there is no longer any profit for the banks in this business. They have withdrawn their bids. We have lost a buffer. Bond markets are going to become more volatile. Because of this reduced liquidity, bond funds are being forced to sell their best quality assets. Their remaining portfolios are much lower quality.

How do we respond to all of this? My feeling is we have seen the surge in interest rates. From now on, the upward trend is likely to be gradual. As a result, bonds are still relatively unattractive for investors seeking income. Bond funds, which depend on trading profits for their performance, are going to struggle in the new bear market.

So at the risk of sounding like a broken record, I think small investors should keep their bond commitments to a minimum and stay with government issues of five-year term or less. That way, you can earn an unexciting but acceptable return and know that your capital is safe. For example, as I write, the Province of Alberta 5.03% bonds due 2018 are trading at $109.80 and yield 3.07%. You are also positioned to reinvest when yields are likely to be more attractive. Avoid long-term issues because they are going to drop in value as rates rise. Steer clear of high yield (junk) bonds. They are too expensive vis-à-vis investment grade debt.

Preferred shares are still a much better bet for income. However, I would sacrifice a little yield and avoid straight (perpetual) shares. Opt instead for issues with a reset provision a few years out. The BCE First Preferred Shares Series 5 (TSX: BCE.PR.S) on our Buy list fit the bill. Trading at $23.80, they pay a $0.75 annual dividend and yield 3.2%, equal to about 4.5% from a bond in an unregistered account after adjustment for the dividend tax credit. They have what is essentially a reset provision on Nov. 1, 2016. You will then be able to benefit from any interest rate increase during the next three years.

REITs have been oversold and some of them now represent excellent value. Flagship RioCan (TSX: REI.UN) dropped 14%. That spells “buying opportunity.” Crombie (TSX: CRR.UN), which we recently recommended as a Sell at $15.80 to take a 35% capital gain, is now very attractive at $13.35. With a solid $0.89 annual distribution, the units yield 6.6%. The big news is Empire Company, Crombie’s parent, has acquired Canada Safeway for $5.8 billion. The deal creates an opportunity for Crombie to buy associated prime real estate for $1 billion. This would be a transformational acquisition for the REIT. I will update Crombie when more details emerge but right now it is reinstated as a Buy for income and growth. Here at Income Investor, we do not set targets but Bay Street expects to see the units at $16 despite the sector being out of favour.

Tom Slee managed millions of dollars in pension money during his career and is an expert in fixed income securities.

 

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THE DEAL WITH CORPORATE REITS

By Tom Slee, Contributing Editor

A reader recently asked us to explain why markets have been responding favourably to major corporations spinning off their real estate into publicly traded REITs. At first glance, it looks as though the corporations are just shuffling assets. Yet in every case the stocks have jumped in value.

There are several big advantages in launching a REIT. First and foremost, it unlocks value. Many companies such as retailers and banks are sitting on vast properties, steadily increasing in value, which are never reflected in the stock market. These days, analysts and investors are focused on earnings, not balance sheet items and for good reason. Balance sheets are suspect and sometimes misleading. For example, assets are usually shown at historical cost and lumped together. There is no indication of their potential and it’s usually difficult to get this information. So hardly anybody uses book value (total assets, less liabilities, divided by the number of common shares outstanding) when valuing a stock. As a result many of the more mature corporations are really undervalued.

Recently Loblaw and now Canadian Tire solved this problem. Both have announced creation of REITs that will hold most of their properties valued at today’s prices. They intend to retain most of the units but offer sufficient public distribution to provide the companies with a huge injection of new capital for new acquisitions. At the same time, they are diversifying into the lucrative property business and this will eventually bolster earnings. The Canadian Tire spinoff is a good example of how the process works.

In May, Canadian Tire announced its intention to create a $3.5 billion REIT to initially hold properties totalling 18 million square feet. The company will retain 80% to 90% ownership in the REIT. As a result, the company is going to receive a capital injection of approximately $500 million for expansion and acquisitions without incurring new debt or diluting equity with a stock issue. It intends to expand its REIT through outside opportunities and nearly all of these profits will flow to the parent and lift corporate earnings.

Despite mediocre earnings, Canadian Tire’s stock promptly jumped 11.2% or $8.32 to $82.36 when the announcement was made. Analysts, now able to value at least some of the major assets, started to use net asset value to assess the shares. Targets were raised from the $80 level to $95 or more. Given that reception, we may see other companies decide to unlock their intrinsic values.

 

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JULY?S TOP PICK

Here is our Top Pick for this month. Prices are as of close of trading on July 22 unless otherwise indicated.

iShares S&P Global Water Index Fund (TSX: CWW)

Type: Exchange-traded fund
Trading symbol: CWW
Exchange: TSX
Current price: $19.65
Entry level: Current price
Annual payout: $0.44
Yield: 2.2%
Risk rating: Moderate risk
Recommended by: Gavin Graham
Website: http://ca.ishares.com

The business: The water industry is a US$500 billion business, growing at 7% per annum or twice the rate of global GDP growth. This is driven by the ubiquitous nature of its product (everyone needs water to live) and the urbanization of the middle class in emerging markets. As the latter move from the countryside to cities and begin to live in modern buildings, they will demand access to safe, unpolluted and readily available water supplies for drinking, hygiene and sewage disposal. There’s also the legacy of underinvestment in aging water and sewage systems in the developed world. As the world continues to grow, it produces higher levels of waste and pollution. Investment in cleaner, more efficient resource use, such as filtration systems, power-efficient pumps, metering systems, inspection and replacement technology for pipes and networks and desalination are vital and crucial to success in the water industries.

The security: Formerly one of the Claymore sector funds launched six years ago, CWW was retained by iShares after its takeover of Claymore last year. CWW holds 50 stocks listed in developed and major emerging markets, equally divided between water utilities and infrastructure and water equipment and materials, such as pumps, valves, filters, pollution control equipment and disinfecting chemicals. Investments include both small and large-cap stocks. CWW’s largest holding (at 7.1%) is in Pentair (NYSE: PNR), a U.S.-based company that produces pipes, valves and filtration equipment. Other water equipment companies among its top 10 holdings include Swiss-based Gerberit (5.8%), U.S.-based Danaher (5.8%) and Swedish group Alfa Laval (4%). Capital goods comprise 42.5% of the fund, while utilities make up another 27% and materials 5.6%.

Why we like it: CWW has shown annual dividend growth of 7.6% over the last five years. Water utilities are generally able to grow their dividends with a fair degree of confidence since they are almost always regulated and permitted to raise their prices by some formula (usually inflation minus 2% to 4% per annum). This encourages the water industry to invest in their infrastructure and earn a real return while promoting efficiencies.

Financial highlights: CWW has achieved a 5% total return compounded over the last five years and 26% over the last 12 months, compared to -0.3% and 11.5% over the same periods for the TSX 60. This makes it a good and less volatile alternative to the Canadian index and to the current bond markets.

Risks: CWW only has $30 million in assets under management. That said, it has a long enough track record and a reasonable 0.67% management expense ratio to make it worth considering.

Distribution policy: Distributions are a bit inconsistent for this ETF. CWW paid distributions of $0.065 a quarter for the first three quarters of 2011 but upped that to $0.09 in December 2011 for a total of $0.27. In 2012, CWW then paid $0.042, $0.05 and $0.06 for the first three quarters before paying $0.26 in December, for an annual total of $0.41. So far this year, CWW has paid two quarterly distributions of $0.061. The payout and yield shown above is based on the trailing 12-month distributions.

Tax implications: Distributions from this ETF are treated mainly as fully taxable foreign income. You may wish to hold the units in a registered plan to avoid this. Any profit or loss on sale or redemption is treated as a capital gain or loss at the time if the units are in a non-registered account.

Who it’s for: This is suitable for investors who are looking for income that will be reasonably resilient in the face of monetary tightening. Utilities have proved to be an attractive target for pension funds, given their relatively high yields, the long-life nature of their assets and the inflation-protected charging structure permitted by governments.

How to buy: These securities are listed on the TSX and available through any broker or dealer.

Summing up: CWW is a more defensive means of providing some reasonable income with a degree of inflation protection.

Action now: Buy at $19.65. – G.G.

 

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JULY UPDATES

Here are this month’s updates. Prices are as of the close of trading on July 22 unless otherwise indicated.

Enerplus Corp. (TSX, NYSE: ERF)

Type: Common stock
Trading symbol: ERF
Exchange: TSX, NYSE
Current price: C$17.07, US$16.49
Originally recommended: Dec. 19/12 at C$12.62, US$12.82
Annual payout: $1.08
Yield: 6.3%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.enerplus.com

Comments: When I last reviewed Enerplus in May, I changed my recommendation to Hold because of the price increase of almost 30% since the original recommendation last December. Since then, we’ve seen a small uptick in the price but nothing significant, confirming my view that the shares are fairly valued at this level.

In recent news, the company announced in late June that it is selling some of its non-core assets for $80 million. They are described as “non-operated properties producing approximately 1,000 boe/day (barrels of oil equivalent per day), of which roughly 90% is weighted to crude oil and natural gas liquids. The properties are being sold to multiple parties.” Enerplus expects the deals to close during the current quarter.

Some of that money ($30 million) is being used to acquire an incremental 50% working interest in the Pouce Coupe South Boundary B Unit #1. Enerplus is the operator of this property and now has an approximate 100% working interest. The additional interest in this light oil waterflood property produces approximately 375 boe/day and has a low historical decline rate of roughly 5%. The property has an average netback of approximately $50/boe.

Year-to-date, Enerplus has sold or has agreements to sell $115 million in non-core assets. Despite this, the company is maintaining its production guidance for 2013 at about 85,000 boe/day.

The shares pay $0.09 a month ($1.08 per year) to yield 6.3% at the current price.

Action now: Hold. – G.P.

Bissett Canadian High Dividend Fund (TML205)

Type: Mutual fund
Code: TML205
Current price: $15.72
Originally recommended: July 27/11 at $15.58
Annual payout: $0.74
Yield: 4.71%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.franklintempleton.ca

Comments: This fund hasn’t provided much in the way of capital appreciation but it has been a steady cash producer in the two years since I recommended it. The portfolio focuses on small to mid-cap stocks and includes a number of former income trusts, which have converted to corporations but still offer above-average yields. These include Medical Facilities Corp., New Flyer Industries, Morneau Shepell, Freehold Royalties and Crescent Point Energy. Several of the names will be familiar to readers as current or past recommendations of this newsletter.

The basis distribution is $0.055 a month but every third month this is increased to $0.075 per unit, for a total of $0.74 per year. In addition, there may be a year-end capital gains distribution, which was $0.415 per unit in 2012. Some of the distributions are tax-advantaged; last year 36% of the payment was treated as a capital gain, 11% was return of capital, and the rest was classified as full-taxable interest, according to Morningstar. Interestingly, none of the distribution was considered to be dividends, despite the name of the fund.

The fund is performing well thus far in 2013 with a year-to-date gain of 10.3% to July 22. Its track record over the past decade is excellent, beating the category average in all time frames.

Action now: Buy. Note that this fund is only suitable for investors who can tolerate above-average risk. – G.P.

BMO Monthly Dividend Fund (GGF588)

Type: Mutual fund
Code: GGF588
Current price: $9.32
Originally recommended: Oct. 23/03 at $8.90
Annual payout: $0.42
Yield: 4.5%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.bmo.com/home/personal/banking/investments/mutual-funds/funds

Comments: This fund was originally part of the Guardian family but owner BMO dropped the name earlier this year and folded the fund into its Advisor series. The management team remains the same, however.

The fund has been a credible performer over time but lately its results have slipped in comparison with the peer group. The fund had a one-year gain of 6.1% to June 30 and is only up about 2% so far in 2013.

The portfolio is a mix of high-yield common stocks such as Shaw Communications and preferred shares from leading companies. The preferred share content was a plus when interest rates were low but it adds more risk during a time when rates are expected to rise.

There are better choices now available for investors who want income-oriented mutual funds so I suggest cashing in your units and moving on. If you want to invest in something similar, try the CI Signature Dividend Fund, updated below.

Action now: Sell. – G.P.

CI Signature Dividend Fund (CIG610)

Type: Mutual fund
Code: CIG610
Current price: $13.24
Originally recommended: Sept. 17/04 at $12.69
Annual payout: $0.48
Yield: 3.63%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.cifunds.com

Comments: This fund follows a similar mandate to that of the BMO fund, investing in a mix of blue-chip stocks and preferred shares. The difference is that this fund does it better. It has been an above-average performer over all time frames from three months to 10 years while providing steady monthly cash flow, currently $0.04 per unit. The management team is led by Eric Bushell, who is one of the best in the business.

This fund offers a global portfolio. About half the assets are in Canada with 22% in U.S. securities, 16.7% in Europe and the rest spread around. Risk is on the low side for a fund of this type but don’t lose sight of the fact it’s an equity portfolio. If the stock market crashes, this fund will be hit as it was in 2008 when it dropped 26%. The large position in preferred shares could also be vulnerable when interest rates rise.

That said, the fund has been a strong performer so far in 2013 with a year-to-date gain of just over 9%. It remains a good choice for investors who want a combination of cash flow, relatively low risk, and modest growth potential.

Action now: Buy. – G.P.

Phillips, Hager & North High Yield Bond Fund (PHN280)

Type: Mutual fund
Code: PHN280
Current price: $12.12
Originally recommended: June 24/03 at $10.87
Annual payout: $0.60
Yield: 4.95%
Risk Rating: Moderate risk
Recommended by: Eric Kirzner
Updated by: Gordon Pape
Website: www.phn.com

Comments: All bond funds are vulnerable when interest rates rise but high-yield funds often fare better than those that invest in conventional debt securities. Plus, this is one of the lowest risk funds of its type, which makes it even more important to hang on to your units if you are lucky enough to own any. (The fund is closed to new investors although current unitholders can add to positions.)

The fund invests in an international portfolio of high-yield corporate bonds, mainly in the U.S. (55%) and Canada (40%). Most of the assets fall into the “junk bond” category, with 70% of the portfolio rated BB or lower. Despite this, the fund has an enviable safety record; the worst loss in any 12-month period was 3.75% in the year to Oct. 31, 2008.

Over the year to June 30, the fund generated a return of 6.3%. The average annual compound rate of return in the decade since we originally recommended it was 7.8% so this is a class buy-and-hold fund for the fixed-income section of a portfolio.

Distributions are currently being paid at a rate of $0.15 per quarter or $0.60 annually. There may also be a bonus capital gains distribution at year-end; in 2012 it was $0.144 per unit. The MER is a very reasonable 0.89%.

Action now: Hold. – G.P.

Phillips, Hager & North Short Term Bond and Mortgage Fund (PHN280)

Type: Mutual fund
Code: PHN250
Current price: $10.43
Originally recommended: May 26/04 at $10.14
Annual payout: $0.24
Yield: 2.3%
Risk Rating: Conservative
Recommended by: Gordon Pape
Website: www.phn.com

Comments: It is possible to lose money on this fund if interest rates go the wrong way, but it’s not likely to happen and if it does the loss will be small. The worst 12 months in its history was a decline of just over 2% in the year to Jan. 31, 1995, almost two decades ago. The fund has not had a year of red ink in many years.

The portfolio is a mix of high-quality government and corporate bonds (rated BBB or better), CMHC and conventional mortgages, and cash (18.4% of total assets). It’s about as low-risk a bond portfolio as you’ll find with a duration of 2.3 years. Even at that, it lost 0.57% during June.

You won’t get rich with this type of fund. The objective is to protect capital and to generate a modest return, which this fund does very well. Over the past five years, the average annual compound rate of return was 3.8% but don’t expect anything approaching that in 2013. The year-to-date gain is just 0.75% so for the full year look for a return of between 1.25% and 1.5%.

The MER is only 0.61%, very low for a mutual fund of this high quality.

Action now: Hold. – G.P.

Phillips, Hager & North Total Return Bond Fund (PHN340)

Type: Mutual fund
Code: PHN340
Current price: $11.43
Originally recommended: Jan. 21/09 at $10.59
Annual payout: $0.36
Yield: 3.4%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.phn.com

Comments: There’s more risk here than in the Short Term Bond and Mortgage Fund but greater return potential as well. Over the three years to June 30, the fund posted an average annual compound rate of return of 4.3%, almost a full percentage point higher than the category average. Recently, it’s been a struggle for the managers, however. The fund gained only 0.37% in the latest 12 months and is in the red by 0.73% so far this year. That’s not a disaster, of course, but it’s a foretaste of what to expect as rates rise.

The fund invests primarily in high-rated Canadian bonds, with about 56% of the assets rated AAA or AA. The management team can also invest in foreign and high-yield bonds but right now those positions are negligible.

I regard this as a core fixed-income fund but the reality is that we’re unlikely to see any significant gains for some time and may even experience some small losses. However, the managers have shown an ability to minimize the downside risk; the worst period in the fund’s history was a decline of 0.76% over the year ending Feb. 28/09.

Action now: Hold. If you want to reduce risk, move some of the assets to the Short Term Bond and Mortgage Fund. – G.P.

RBC Canadian Equity Income Fund (RBF591)

Type: Mutual fund
Code: RBF591
Current price: $24.89
Originally recommended: Dec. 9/09 at $19.19
Annual payout: $1.08
Yield: 4.34%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: http://funds.rbcgam.com/

Comments: I originally recommended this fund for a combination of cash flow and growth potential and it has delivered on both counts. At the time I advised buying, the fund was paying monthly distributions of $0.0625 per unit or $0.75 a year to yield 3.91%. Now the monthly payment is up to $0.09 a unit ($1.08 a year). So even though we have had a price appreciation of $5.70, the yield is actually higher today. If you bought at the time of the original recommendation, the yield on your cost price is 5.63%.

Not only that, the fund has managed to significantly improve its net asset value over the past year despite the higher payout. That’s the kind of performance we like to see.

The portfolio invests primarily in Canadian stocks (80.7%) with a small position (10.8%) in the U.S. equity market. The focus is on large cap stocks which is a sea change from the original style which focused more on income trusts and companies that had converted from trust status. It’s clear from the results that managers Brahm Spilfogel and Jennifer McClelland have handled the transition well; the fund shows a three-year average annual compound rate of return of 15.6% and has gained 7.6% thus far in 2013.

Action now: Buy. This fund has done everything we expected, and more. – G.P.

Chemtrade Logistics Income Fund (TSX: CHE.UN, OTC: CGIFF)

Type: Income trust
Trading symbol: CHE.UN, CGIFF
Exchange: TSX, Grey Market
Current price: C$17.07, US$16.49
Originally recommended: Dec. 21/11 at C$14.08, US$13.56
Annual payout: $1.20
Yield: 6.9%
Risk Rating: Higher risk
Recommended by: Tom Slee
Website: www.chemtradelogistics.com

Comments: Chemtrade, a leading marketer of sulphuric acid, liquid sulphur and ultra pure acid, continues to make solid progress. The first quarter 2013 operating profit of $38.6 million was in line with consensus forecast and the company is on track to earn distributable cash of $1.65 a unit in 2013. Analysts expect an increase to about $1.95 in 2014. That means the current $1.20 distribution represents conservative payout ratios of 73% and 62% respectively.

The trust continues to negotiate risk-sharing contracts to protect its cash flow. International sulphuric acid markets have weakened recently but Chemtrade’s pulp margins are stable. Excess cash flow is being used to reduce debt. The distributions are sustainable. It currently yields 6.9%.

Action now: Buy. – T.S.

 

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YOUR QUESTIONS ANSWERED

PIMCO Monthly Income Fund

Q – I am looking at the PIMCO Monthly Income Fund and am considering investing in it. Can you explain how it has done so well for a fund that is advertised to be low risk and would you recommend it? – Ken L.

A – There’s no question the fund has been impressive since it was launched in January 2011. It gained almost 16% over the year ending June 30 and was showing a two-year average annual compound rate of return of 15.1% at that point. But don’t be blinded by those numbers. As of the close of trading on July 19, the fund was only showing a 3.3% year-to-date advance and was down 0.6% over the previous 30 days. In other words, it’s running out of steam.

It’s not hard to understand why. The fund invests in a portfolio of foreign bonds and mortgages, primarily denominated in other currencies. The bond market remained strong in 2011 and 2012 as yields declined in the face of a slow-growth global economy. This year we have seen commercial rates starting to inch higher, even though central banks continue to hold the line. Rising rates are bad news for fixed-income investments because as yields move higher, prices decline.

PIMCO, which is based in southern California, is one of the most respected fixed-income traders in the world. But even it cannot hold back the tide although through astute security selection, its managers can mitigate losses. One of the ways they achieve this is by shortening the average term of the securities in the portfolio; as of June 30, the fund’s duration was only 4.4 years. (Duration is a measure of a fund’s sensitivity to interest rates; the higher the duration the greater the risk. The DEX Universe Bond Index has a duration of about six, so this fund has below average rate sensitivity.)

The fund pays monthly distributions which have generally run between $0.04 and $0.05. Over the year to June 28, it paid out $0.6127 per unit, which works out to a trailing yield of 4.4% based on the July 19 net asset value of $14.02. The price over that period increased by $1.37 which is a very healthy sign.

This is a first-rate fund if you are looking for exposure to the international bond market, top-quality management, and a decent yield. My main concern is the negative effect of rising interest rates on the return. That said, the year-to-date return is comfortably positive and puts this fund among the best performers in its category so far in 2013. – G.P.

Enervest Diversified Income Trust

Q – I would like to know if the Enervest Diversified Income Trust is a good investment. It is trading at $11.69 (July 19) but the net asset value is $13.57. Annually the company allows redemption at 95% of NAV. The holdings are blue-chip Canadian stocks and good quality bonds and debentures. In 2012, 65% of the distribution ($0.10 monthly) was return of capital and 35% taxable dividends. – Max V., Vancouver

A – Enervest is a $1.1 billion closed-end fund that trades on the TSX. Such funds normally trade at a discount to NAV so the price differential is not unusual. About two-thirds of the portfolio is in Canadian equities with stocks such as Royal Bank, Scotiabank, Suncor Energy and Canadian Natural Resources topping the list. Of the remaining assets, 16.5% are in U.S. stocks, 3% in international equities, 12.3% in bonds and 4.3% in cash.

According to the company’s own website, recent performance has lagged the benchmark which is the S&P/TSX Total Return Index. The fund posted a gain of 8% over the 12 months to May 31 compared to 13.3% for the benchmark and showed an average annual loss of 1.9% over two years. Taking the longer view, the fund just about matched the TSX over the past decade with an average annual gain of 9.2% compared to 9.1% for the index.

Distributions have remained steady at $0.10 a month since 2010, which works out to a very attractive yield of 10.3% based on the current market price. However, both the NAV and the market price have declined over that time some investors have given back some of their cash flow in the form of a loss of equity.

Although we have recommended a few closed-end funds over the years, none has ever turned out to be an outstanding performer. Enervest appears to be no exception. If you like the cash flow, go ahead and invest but be prepared for the possibility of a gradual decline in market value over time, in part due to the relatively high management expense ratio of 1.73%. – G.P.

 

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That’s all for this issue. Look for your next Update Edition on Aug. 15. The next regular issue will be published on Aug. 29.

Best regards,
Gordon Pape, editor-in-chief