What would you say to a fund yielding 9.0% with highly tax-efficient distributions?

Sound appealing? It’s available, but it also comes with risks we fear some investors are overlooking.

Everyone wants yield. We can see this in the number of new income-oriented products and the heavy promotion of existing ones. Flipping through a recent investment magazine there were 20 full-page ads, with no less than 10 of them devoted to advertising income related products. Higher yields are alluring in today’s low interest rate environment, but it’s time to take a closer look at the risk of chasing yield.

We like to learn from history and chasing yield is not a new phenomenon. Today’s proliferation of high-yielding income funds reminds us of the Income Trust craze. So what lessons can we take from Income Trusts? Five years ago, we saw businesses that made poor candidates as dividend-payors, transform themselves into income trusts for the tax advantage of the distributions and to attract more investors. Many of these businesses had cash flows which were either too variable or too small to support the size of distribution they promised. The result was they distributed more cash flow than they earned and had to either take on more debt or “sell the furniture” to keep up. When the Hon. Jim Flaherty killed the Income Trust structure on Halloween 2006, these high-paying investments had to revert to relying on the quality of their underlying business to generate returns for their investors. Unfortunately, many investors had been evaluating these income trusts on their yield alone and were disappointed to learn neither the yield nor valuation was sustainable without the income trust structure.

Investing based on yield alone can frequently end in disappointment. Higher yields do not indicate better investments, in fact, they can sometimes point to more dangerous ones. Higher yielding bonds, for example, can imply more credit risk, a greater chance you will not get all your money back. Alternatively, higher yields can be a result of unusual features embedded within the bonds’ terms. Experienced credit analysis is required to navigate these bonds profitably. High dividend paying stocks could suggest a cut in dividends is coming or that the Company is overpaying dividends at a cost to the growth of the business. As we will see, a business or fund can payout any level of headline yield they like … over the short-term. This is why it is essential to understand the underlying investment and the risks that lie beneath the headline yield.

Today, some of the monthly income funds offered by Canadian banks look very attractive offering yields as high as 9%. As my Father used to say, if it sounds too good to be true, dig deeper. The question then becomes, with yields on government bonds averaging 2.5%, good quality companies paying dividends of 2 to 4% and mutual fund fees costing on average 2 to 2.5%, how are these funds able to pay out 9%? Simple, yield is not the same as income.

There is a difference between the headline yield advertised and the investment income the fund earns from its’ investments. Headline yield can be made up from four sources; interest income, dividends, capital gains and return of capital.

The last component, return of capital or ROC, allows funds to commit to pay any level of yield they wish, regardless of their investment returns. This is because ROC, in plain English, is the fund manager giving you back your own money without any investment return (that’s the tax-free component). Oh, and by the way, you won’t know how your payouts are broken down until after the yearend when the annual Management Report of Fund Performance (MRFP) is published.

It isn’t necessarily bad for funds to target a headline yield, it offers investors the ability to budget. However, unattainably high headline yields could influence managers to make decisions to the long term detriment of your investment. Starting to sound familiar?

For example, a fund manager may wish to avoid paying out capital from the fund (remember they are incented to grow the capital they manage, not give it back), so they may be motivated to reach for high yielding, risky investments to satisfy the high targeted payout of the fund. Another issue with promising a high headline yield is a manager may attempt to increase capital gains to offset the amount of ROC needed to meet the yield commitment. In this case, they could be incented to sell the winners in the portfolio prematurely in order to crystallize the gains. Neither strategy is good for the long term sustainability of a fund.

So what do we recommend? Stick to a fund that you understand, charges a reasonable fee of 1.5% or less and limits the distribution to the income they’re earning. This may produce a lower yield than you would like, or need, but you can always supplement the income by selling some of your holdings to make up the difference (i.e. determining your own ROC). This way you are in control of how much of your own capital you take back and the manager won’t be incented to take undue risk. Lastly, avoid funds with complicated income strategies you don’t understand. Not understanding what you own is, in our view, the most significant risk to any investor.

Remember the Income Trust experience when evaluating today’s high yielding income funds and always Beware of the Yield.

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. All tax decisions should be made after discussing your individual positioning with a qualified tax accountant, as everyone’s tax situation is unique. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

As 2011 comes to a close, investors continue to be bombarded by daily news of economic and political problems.  In the U.S., housing prices remain depressed, the unemployment rate remains stubbornly high, and the politics surrounding the upcoming Presidential election and taming the federal debt have raised questions as to the political will to fix the problems.  In Europe, debt levels are at dangerous highs and climbing, economic growth is weakening, and investors are questioning the ability of politicians to put in place an effective, timely, and long lasting solution to the Euro crisis.  Is it any wonder that investors are losing hope?

While we believe that the U.S. economy will continue to recover, and that Europe will eventually resolve its debt crisis one way or another, these events highlight how difficult it is to foresee the direction of the market over the short term.  That is why it is more important than ever to use history to put today’s events in context and to focus on indicators of long-term value.

A common concern for the U.S. economy is that this recovery looks quite different than any other since World War II.   In fact, if you look over the past five U.S. recessions, you see a consistent pattern where this recovery has been much slower in terms of economic growth and unique in terms of the lack of improvement in the unemployment rate.

However, it may be that the last five US recessions are not the most appropriate comparison.  What makes the 2008 downturn unique among post World War II recessions was the severe financial crisis and synchronous global contraction that accompanied it.  To better understand the path to recovery, it is necessary to look at a broader set of economic crises across countries as well as over time.

At last year’s Federal Reserve symposium at Jackson Hole, Wyoming two economists named Reinhart presented a paper titled “After the Fall” (footnote: www.kansascityfed.org/publicat/sympos/2010/reinhart-paper.pdf).  The authors looked at 15 severe post-World War II financial crises in advanced and emerging economies and three synchronous global contractions.  A disquieting finding was that while the biggest impact of these crises occurred in the first few years after the event, the negative effects persisted for a full decade or more.  Specifically, they found that over the next decade, economic growth tended to be about 1% slower and unemployment tended to be on average 5% points higher.  Real house prices tended to be 15 to 20% lower at the end of the decade compared to the year before the financial crisis started.  Also of note, despite massive stimulus from fiscal policy, monetary easing, and currency devaluations, inflation was typically lower, not higher.

So are we headed for a lost decade in the U.S., similar to the Japanese experience of the 1990’s?  Both have suffered a real estate crisis.  By some estimates, close to a quarter of US mortgage holders owe more than their mortgages are worth.  Even with the current high levels of foreclosures, we are likely several years from clearing through this “shadow inventory” of yet to be foreclosed upon homes.  This will continue to weigh on house prices as well as consumer confidence.

On the other hand, there are two key differences in the U.S. that we think will drive a different course.  First, the U.S. corporate sector is in much better shape than its Japanese counterpart was.  Corporations are not overly levered and are holding record cash balances.  Second, banks in the US have been much quicker to take write-downs from non-performing loans and raise capital to improve their capital situation.  We expect the strength of the corporate balance sheet in the US will likely continue to support modest capital expenditures and job growth.  After all, despite the headlines, the US has created almost 3 million net private sector jobs over the past two years.  However, the overall level of unemployment will most likely be held back by a mismatch in the skills of workers and jobs as well as the skill degradation that comes from long-term joblessness.

Europe is another matter, and is the biggest risk to this more tempered view of the US economy.  The term “sado-fiscalism” has been coined to describe the fiscal austerity needed to resolve the government debt crisis and keep the Euro currency in place.  This will likely lead to a sustained economic slowdown in Europe that will reduce US exports and the revenue growth from multinational corporations.  However, the larger risk is from financial market contagion and the impact of sovereign bond exposure on European banks.  Policy makers are very focused on trying to control the potential risk of a messy 2008 like collapse, however the risk remains elevated and has been a key driver of recent capital market movements.

So what does this mean for a Canadian investor?   While history tells us that there is a long road to recovery after a crisis, the good news is that the level of valuations for equities is consistent with long-term returns in the high single digits.  Although these returns are below those of the 80s and 90s, they are still quite attractive, especially when compared to the low level of yields offered from fixed income investments.  The real challenge for investors will be developing a strategy to weather the volatility that is required to capture these returns.

In highly volatile markets, we advise investors to take one of two approaches.  The first is to ignore the temptation to react too quickly to the headlines and focus on the longer term.  Easy to say, but it can be challenging for even the most patient investors.  Alternatively, investors can take advantage of the opportunities that arise as market corrections punish both strong and weak companies.  We look to add to companies where expected returns have improved from market declines and where we can build the confidence that the company’s business model is robust enough to weather this sustained period of uncertainty.

Jim Gilliland is head of fixed income at Leith Wheeler Investment Counsel Ltd. of Vancouver, a firm with assets of $11 billion.  David Schaffner is the firm’s president and CEO.

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. All tax decisions should be made after discussing your individual positioning with a qualified tax accountant, as everyone’s tax situation is unique. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

The month of December brings on challenges for procrastinators in a race to ensure the last deadlines of the year are met. To help alleviate some of the stress of the holiday season, we have compiled a list to help ensure your financial affairs are organized at year-end, so that friends, family and charities benefit, rather than the tax authorities.

Naughty & Nice Ways to Pay for an Expensive Month

Whenever you tap your investment portfolio for holiday spending, a tropical vacation, or any other cash need, ensure that you raise the money in a tax-efficient manner.  After cash in the bank, your Tax Free Savings Account (TFSA) should be the next best source of funds, and December is the most advantageous month to draw from it.  The money taken from a TFSA can be replaced entirely in January 2012, along with your new maximum annual contribution, so the impact of withdrawing money from this tax-sheltered account is minimal.

A taxable portfolio of securities is a less desirable source of cash because capital gains will be triggered if the securities sold to raise it have appreciated in value.  On the other hand, if you own a security that has declined in value below its cost base, the loss triggered by its sale can be applied against capital gains on your prior three tax returns, or carried forward against future capital gains indefinitely.  However, if you buy back the same security within 30 calendar days the loss will not be allowed by the Canadian tax authorities (CRA).  Also note that, ‘tax loss selling’ must be done by December 23 to be applied to the 2011 tax year.

If you are 71 or older, a Registered Retirement Income Fund (RRIF) may be the next best source of cash as a minimum income withdrawal is required each calendar year after age 71.  If you have not drawn out your minimum by December, it will be paid to you by year-end.  If you decide to draw out more than your minimum be aware that withholding taxes will apply to the amount withdrawn in excess of the minimum.

Typically, the least desirable source for short term cash needs is a Registered Retirement Savings Plan (RRSP) because cash withdrawals can’t be replaced. This will result in both a high tax cost and the benefit of tax-sheltered assets is lost.

Give the Gift of Education

Parents and grandparents can fund a Registered Education Savings Plan (RESP) for post-secondary education for their children and grandchildren. The Federal Government provides a 20% grant each calendar year, so ensure that the maximum is contributed by December 31 to receive your benefit.

Support Those in Need

Making a cash donation to a charity from an investment portfolio has the same tax implications outlined above, and careful attention must be taken to avoid triggering a tax bill.  Donating an appreciated security is a tax-advantageous gift because you avoid capital gains tax and enjoy the benefit of a tax deduction for the full value of the security.  A stock with a large capital gain that you were thinking of selling is the perfect candidate for donation. Act at least two weeks before the end of the year to ensure that all of the paperwork between your investment manager and charity can be completed in 2011.

Reduce Your Gift to the Tax Collector

Year-end is also an appropriate time to review the account structure of your portfolio to ensure that investment returns are being received in a tax-efficient manner. Generally, investments paying interest income should be in tax-deferred accounts (RRSP, RRIF and TFSA) and investments that generate dividend income (especially Canadian) and deliver capital gains should be in taxable portfolios (personal or corporate). Additionally, U.S. assets should be held as ‘Canadian,’ either through a Canadian mutual fund or a corporate account, to avoid U.S. estate taxes.

Don’t Forgot About Your Accountant

Determining your investment income before the end of the year can give you a head start on planning for tax season. If you own stocks and bonds it is a simple calculation to add up your interest income, dividends received and realized capital gains in the year. If you own pooled or mutual funds, ask your fund manager for an estimate of the year-end distribution.  Knowing the numbers will help your accountant determine whether OAS clawbacks may occur next year and if the timing of income recognition or withholding tax may be appropriate.  Estimated year-end mutual fund distributions can also be useful when planning the timing of future mutual fund purchases. Finally, ensure that you make deductions for all allowable expenses when preparing your tax return.  For example, investment counsel fees paid on taxable accounts are deductible, as are interest costs.

A Good Investment can be a Gift that Keeps on Giving

At this time of year, our attention can be diverted from our ultimate investment goals by the myriad of tax-driven investment products on offer. Despite the theme of this list, never make an investment based solely on its tax benefits. All investment decisions should be driven by you or your advisor’s view of the value of the underlying security and its suitability relative to your long term investment objectives.

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. All tax decisions should be made after discussing your individual positioning with a qualified tax accountant, as everyone’s tax situation is unique. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

• U.S. publically traded securities held in Canadian brokerage accounts, Registered Retirement Savings Plans (RRSP), Life Income Funds (LIF), Tax Free Savings Accounts (TFSA) or Registered Education Savings Plans (RESP).  (Note that American Depository Receipts for international companies like Sony or Nestle are not considered U.S. situs assets)
• U.S. mutual funds including money market funds (Note that U.S. cash holdings are not considered U.S. situs assets for estate tax purposes.  Also, Canadian mutual funds holding shares of U.S. corporations are also not classified as U.S. situs property)

The Tax Relief, Unemployment Insurance Authorization and Job Creation Act of 2010 that was enacted on December 17, 2010 changed the U.S. Estate tax rules for deaths in 2011 and 2012.  Essentially, the Act reinstated the estate tax at a maximum rate of 35% for 2011 and 2012, and changed the individual credit amount to an exemption equivalent to US$5 million in total worldwide assets.   For 2013 and beyond, unless new legislation is enacted, the exemption will drop to US$1 million in total worldwide assets. Unfortunately, the lack of certainty around the 2013 period requires caution when individuals or families are addressing estate planning issues.  The table below shows the history of the exemption and top estate tax rates over the past 5 years.

It is also important to note that unlike the Canadian tax system, U.S. estate tax applies to the fair market value of U.S. situs assets and does not take into account whether a capital gain has been made on the asset or not.  This means that an investment that lost 50% of its value may still be subject to U.S. estate taxes on the remaining fair market value! Conversely, if a significant capital gain is realized at your death on a U.S. situs asset, there would be a deemed disposition for Canadian tax purposes triggering capital gains taxes, in addition to potential U.S. estate taxes.  In some cases, depending on the individual’s circumstances, the combination of Canadian and U.S. taxes could amount to a substantial portion of the total value of the asset.

The tables below provide some hypothetical examples of how much U.S. estate tax one could expect to incur using various assumptions.  Also to clarify, technically there is no “exemption” of US$5 million.  The law actually states that there is a “unified tax credit” of US$1,730,800, which has the effect of offsetting the U.S. estate taxes applicable to the first US$5 million of taxable estate.  Due to the Canada/U.S. Tax Treaty, a Canadian citizen that resides in Canada would be entitled to a portion of this tax credit in proportion to the ratio of their U.S. situs assets to their total worldwide assets.  The first table lays out potential U.S. estate tax exposure for the 2011 and 2012 period and the second table outlines the theoretical tax exposures from 2013 and beyond.

What does this mean to the average Canadian investor?  Holding U.S. situs assets could be very costly when you pass away.  Given that none of us know our expiration date, some potential estate planning tools that are available to address this issue include:

• Holding U.S. publically traded companies inside a corporation.
• Owning Canadian based mutual funds to get U.S. asset exposure.
• Discussing your individual positioning with your tax accountant, as everyone’s tax situation is different and any tools available should be used after consulting a qualified tax advisor.

The article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

Over the last several years, emerging economies have gained in strength and prominence and helped the world recover from the last recession.  Unfortunately, the high pace of growth and easy credit conditions have led to inflation in many of these economies.   To combat inflation pressures, we have seen a tightening in monetary policy over the past year and the early signs of economic slowing.  China has begun to slow loan growth and is showing preliminary signs of manufacturing slowing.  In Brazil, new concerns around weaker global growth caused the central bank to reverse previous hikes and move to cut interest rates.  The impact of this slower growth has been a softening in commodity prices as emerging markets are the main source of incremental demand.

Finally, amidst these global concerns, U.S. policy makers dealt themselves a self- inflicted wound to confidence by mishandling the increase of the debt ceiling. The follow-on impact from a debt rating downgrade was felt more in stocks than bonds and led most economists to significantly revise down their expectations for second half growth. To help support the economy, the Federal Reserve took two unconventional steps this quarter.  In August, they announced they would attempt to hold the federal funds rate in the 0%-0.25% range until the middle of 2013. At the September meeting, they announced an intention to sell $400 billion in short term bonds to buy longer term debt.  Both of these measures were intended to lower longer term interest rates further and provide a more favourable environment for refinancing mortgages and long term corporate debt, in order to stimulate personal and corporate spending.

Canada has not been immune to these effects.  Canadian stocks and commodity producers in particular are pricing in much slower global growth expectations.  Over the quarter, the Canadian stock index declined just over 12% and the Canadian dollar weakened close to 9%.  Canadian interest rates have declined in sympathy with US rates and have provided positive capital gains in the bond market. 

Outlook

It’s difficult to see how the challenges in Europe can be resolved quickly.  Even with the emergency stabilization fund, another restructuring for Greek debt is likely.  In addition, there are two key structural problems that need to be resolved within Europe.  First, social programs and pension plans have created structural deficits that need fundamental reform rather than just improved financing liquidity.  Second, its not clear that currency unions can be effective without mechanisms for transfer payments to smooth out regional disparities in economic performance.  These fundamental problems are not new, but what is new is investor’s lack of willingness to provide financing at interest rates that ignore these problems.  In the case of the Eurozone, they may not be able to avoid a significant slowdown or potential recession. 

For emerging markets, we have begun to see a reversal of the tightening of policy that has dominated this past year.  Though inflation has not been tamed, recent commodity declines will remove some of the near term pressure.  In addition, emerging markets have much more flexibility than developed economies to provide monetary and fiscal stimulus as well as improved credit conditions. Emerging economies will likely continue to lead global economic growth.

We believe a US recession is unlikely. We are most likely in an environment of 0-2% slow growth. The Federal Reserve has been much more aggressive in providing liquidity than in Europe and excesses in terms of inventories and capacity have not built to levels that have generally preceded recessions in the past.  However, we remain concerned around the potential impact from further budget negotiations and a slowing Eurozone economy.

We are most likely in an environment of continued lower interest rates in Canada over the next 12 months.   We anticipate that the Bank of Canada will need to take further steps to normalize rates but that these steps are probably delayed given the global uncertainty.  Over a longer time horizon, we expect short term rates to normalize in the 2-3% range with long term bonds in the 3-5% range. 

Given this, it is not surprising that some investors are losing faith in equities. However, now is not the time to be selling. While we can not predict the timing of a market recovery, we know there will be one. There is also no telling what form of catalyst could emerge to provide a market rebound. It could be a European debt restructuring, better than expected economic growth in emerging countries or the United States or it could be something that no one is expecting. Financial markets will often rise before the economic statistics and popular media tell us a recovery is taking place.

We believe large market declines provide an opportunity to add to our companies where expected returns over the next 3-5 years have improved further, and where we have high levels of confidence that the business models can weather and even grow stronger during periods of uncertainty. For example, CN Rail and Saputo are both selling for 10% cheaper than they were at June 30^th, yet both companies enjoy strong cash flows in good times and bad and their management has a demonstrated ability to reinvest those cash flows profitably.

Even in an environment of 0-2% economic growth environment, we still believe our stocks can provide returns in the range of 6 to 8%. This is attractive in an environment where bond yields have fallen well below 3%. Stocks have disappointed investors lately, but are poised for outperformance relative to bonds, from these levels.

The article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

“Dexia’s position has no impact on RBC Dexia or its operations,” RBC said in a statement. “RBC Dexia’s shareholder agreement is structured to prevent conditions at either parent company from impairing RBC Dexia’s ability to operate as a strong, independent company.”

Dexia SA’s recent troubles may cause them to sell their share of RBC Dexia Investor Services in order to raise cash to repay the government guarantees. RBC has a right of first refusal on the purchase of Dexia’s share of the custodian and, according to recent news reports, are currently in talks with Dexia SA about purchasing the remaining 50% of RBC Dexia Investor Services they do not already own. RBC may eventually own 100% of the custodian but custodian clients should be unaffected.

The article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

Markets have retreated significantly, with the TSX declining another 4% Monday and the S&P 500 dropping 5.5%. The recent weakness in the stock markets has been widely reported as being due to the downgrade on U.S. government long term debt from AAA to AA+ by S&P.  Although this may have served as a catalyst for Monday’s decline, the more significant concerns in the market are fears over debt levels in Europe which have spread to the larger economies of Italy and Spain as well as recent disappointing global economic news. Concern has increased that we may be entering another recession and interest rates may have to increase in the United States at a time when the government’s ability to respond to a slowdown is limited.

What has not been widely reported is that while the stock markets have declined, bond markets have enjoyed a significant rally. The Dex Universe Bond index has increased 3.8% since the end of June. The downgrade by S&P was widely expected and we do not expect it to push up yields in any meaningful way which was, to some extent, confirmed by the lack of response from the bond market on Monday. On a positive note, it has put the fiscal situation in the U.S. under more of a spotlight and should, hopefully, push the politicians into a more credible long term plan to deal with their debt and deficits.

On the economic front, the last month has seen a significant revision in global growth prospects. These revisions have led to corrections in major equity markets globally and declines in interest rates for most developed bond markets. These concerns around growth expectations are somewhat of a reaction to policy tightening in many regions of the world.

Emerging market countries have been leading the global economy higher since the end of the last recession. Unfortunately, price increases in these markets have led to persistent inflation with wage increases becoming routine. To battle this inflation, we have seen a tightening in monetary policy over the past year. In Brazil, overnight rates have increased from 8.5% to 12.5% while in China, short term rates have been increased from 2% to 6%. Though these increases have had only a modest impact on economic performance to date, the market is concerned that a more significant slowdown is underway. Although we expect to see some slowing of growth from the recent lofty levels in the emerging markets, we still expect these markets to be a key engine that keeps global GDP on an upward trend.

In Europe, the ECB has increased interest rates twice this year despite stresses within the periphery countries of Greece, Portugal, and Ireland. Last week’s stock market declines were precipitated by a lack of confidence in the Eurozone’s ability to manage larger debtor countries such as Italy and Spain. Recent economic data has shown only a modest softening in the industrial heartland within core Europe.  However, the stock market has started to discount much slower growth throughout the Eurozone due to continued concerns around peripheral debt levels and the potential impact from weakening emerging economy exports.

In the U.S., most signs are pointing to an environment of continued slow economic growth, and the recent market volatility has increased the downside risk to these expectations. Our economy is closely linked to the U.S., as well as to the rest of the world, so our stock market has fallen in tandem.

The market is concerned that we will see a recession and with the recent economic weakness, the risks of a recession have increased. However, our base case scenario is for the U.S. economy and Europe not to enter a recession but rather to see a low level of growth in their economies despite their fiscal situation and debt levels.

What have we been doing in your portfolio?

At the end of the last quarter, given the heightened economic risks we are facing, we reduced the risks and moved to a more defensive position in client bond portfolios. We accomplished this by increasing the quality of corporate bonds (e.g. we sold some junior bank tier 1 bonds and bought senior ranking bank bonds) and selling some corporate bonds for provincials. We are also positioned defensively from an interest rate perspective to protect bond portfolios from a sudden increase in interest rates.

On the equity side we examined our exposure to Europe both in Canadian and Global client portfolios. In the Canadian portfolio, the exposure to Europe is small and the Global equity portfolio is significantly underweight the core Eurozone market. We estimate that clients’ direct exposure to the countries experiencing significant debt problems (Portugal, Ireland, Italy, Greece and Spain) is less than 2% of the International equity portfolio.

The best way we know to manage risk is to buy stock in, or lend to, companies that can grow with strong balance sheets and good profitability, trading at attractive valuations. In doing so, we assess whether the expected returns are compensating for the risk. Over our 29 year history we have found that this approach has worked best, and has provided good protection without foregoing return. If a company increases its intrinsic value and shares are bought cheaply enough, a patient investor is always rewarded.

Recent economic concerns are surfacing at a time when fiscal and monetary policy levers are limited. Debt levels are high and interest rates are already low. What we are facing is a lack of confidence in the institutions that are responsible for these levers. 

A broad market correction punishes both strong and weak companies. We are using market declines as an opportunity to add to companies where expected returns over the next 3-5 years have improved and where we have high levels of confidence that the company’s business model can weather a period of uncertainty. We plan to maintain the equity exposure in client portfolios.

As always, please contact your Portfolio Manager or Investment Funds Advisor if you have any questions about this topic or your portfolio.

The article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

As you may recall from our Planning Matters presentation last November with Will Todd of Davis LLP, the Internal Revenue Service (IRS) in the U.S. has increased their efforts towards gathering financial information from U.S. citizens living abroad. As part of this effort, the IRS developed the Voluntary Disclosure Program Initiative. The Program allows U.S. citizens living in Canada to fulfill their delinquent IRS filing requirements with limited or no penalties. The deadline for the IRS Voluntary Disclosure Program is August 31, 2011. Extensions are also available under certain circumstances.

More information is available from the IRS website http://www.irs.gov/newsroom/article/0,,id=234900,00.html

 If you believe the Voluntary Disclosure Program may apply to you or any of your family members, we strongly urge you to contact your tax professional immediately to see what can be done before the August 31^st deadline.

If you are not in contact with a tax professional, you can contact us and we can recommend individuals and firms with experience in these filings.

The attached does not constitute legal or other advice and is not intended to provide recommendations or offers to buy or sell any product or service.

How We Got Here

There have been a lot of events that one can point to as the start of the crisis but most would agree the origins lie with the start of European monetary union in 1999.  From the start there was a lot of skepticism that countries could share a currency without also sharing control of fiscal policy.  There was an attempt to address this issue by placing restrictions around how much debt and deficit spending each of the countries in the Euro could have (no more than 60% debt to GDP (‘Gross Domestic Product’) no more than 3% of GDP budget deficit per year) but with no real enforcement mechanism, these restrictions have been largely ignored.   What the Euro allowed countries like Greece to do was borrow at artificially low rates made possible due to their new ties with strong partners like Germany and to put off economic reforms necessary to keep their economy competitive.  When the credit crisis and accompanying deep recession hit, not only did the Greek budget deficit balloon to over 15% of GDP, but it was revealed that the Greek government had been misstating their debt numbers for years.  These realizations caused bond investors to refuse to rollover maturing Greek debt, which in turn forced the other members in the Euro together with the IMF to come up with a €110 billion bailout in May of 2010.  Unfortunately, by the first quarter of this year, it became obvious that the original bailout wasn’t sufficient and that Greece needed another €60-70 billion.   This time around,  the bailout is not a given.  Serious rioting has dominated recent headlines.   Greeks are protesting the package of tax increases  and spending cuts that are a prerequisite of accessing the money from the second bailout package, which itself has not been ratified by the donor countries, who themselves seem to be increasingly reluctant to supply more cash.

Why Does It Matter?

Normally, it would seem odd that a crisis in a country that makes up a mere 2% of Euro zone GDP would command so much attention, so why is Greece so important? One reason is that European banks, especially French and German ones, hold a lot of Greek debt and a default would cause significant damage to balance sheets that still have not fully recovered from the deep recession of 2008-09.  The other, far more important reason, is that Greece was not the only member of the Euro that was able to use its membership of the Euro zone to borrow at artificially low rates.  If you look carefully at much larger and more important members like Italy (7x the size of Greece) or Spain (4x) there are a disturbing amount of similarities to Greece’s finances.  Bond investors are already demanding higher interest rates from these countries and a disorderly default by Greece could easily cause rates to climb to unsustainable levels, and the turmoil this would cause could easily tip the fragile recovery into another recession in Europe.

What Do We Need to Watch?

The recent passage of the austerity package removed a lot of the near term danger of a default by Greece and has resulted in a rally in most of the markets around the world.  However, this doesn’t mean the situation is  resolved.   In the near term, the details of the second bailout package are still to be worked out and ratified, with meetings of all the finance ministers in the Euro scheduled for early July.  Even if the money is raised, it is becoming evident that simply lending Greece more money on an ongoing basis is not sustainable, and some sort of debt restructuring will be necessary.  While we anticipate that a solution will be found, how this is going to be accomplished is going to be source of a lot of tricky negotiations over the coming months.  And although a successful resolution of the problem of Greek debt will help defuse some of the immediate risks facing the Euro zone, we would caution against complacency as it does very little to address the underlying imbalances facing the rest of the members.  We will continue to monitor the evolution of Eurozone policy and the systemic and counterparty risk to your portfolio.

The article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

Dave also discussed Leith Wheeler’s new Income Advantage Fund, designed to help investors deal with the current market volatility and provide them with a steady income stream.

Watch the BNN episode here.