Of Note:

Just as gains in your RRSP are not taxable, losses in it aren't tax-deductible either, so there is nothing to cushion
the pain of losses.


Risk and RRSPs are a bad match

October 8, 2010
The Globe and Mail

Avner Mandelman is a director of Venator Capital Management and author of The Sleuth Investor.


A big mistake even seasoned investors make in their private finances is to take too much risk in their RRSP.

Many people learn to invest through their self-administered RRSP, because the money they contribute annually seems so enticingly available for trading. However, just as gains in your RRSP are not taxable, losses in it aren't tax-deductible either, so there is nothing to cushion the pain of losses.

And those losses can sting. If you lose, say, 25 per cent one year, the next year you must make 33 per cent just to get back to where you started.

Sure, when you're young and your best earning years are ahead, you can take some careful risks with your nest egg. But when your hairs grow greyer (or fewer), you should go for more reliable gains.

I like to aim for a steady return of 8 per cent or so per year. But how can one earn such returns - especially if you prefer to sidestep the risks of stocks and invest mostly in bonds?

It's hard. To get a higher yield on a bond, many investors choose to buy bonds with longer maturities of 10 or more years. The problem with that strategy is the risk that interest rates will rise. Since longer-dated bonds are more sensitive to interest rate changes than shorter maturities, even a modest rise in rates can hammer the value of your bond portfolio.

Another strategy is to buy so-called junk bonds from corporations with below investment-grade credit ratings. The problem here is that the company's cash flow will barely cover the interest charges it must pay - let alone the principal when the bond matures - and so there's high risk of default.

I prefer a third option. I look for shorter-term investment-grade corporate bonds, maturing in three to five years, where the cash flow coverage is sufficient, but not ample, to cover interest payments. I prefer cash flow to be twice or more debt payments. As for the principal, I also insist that there must be ample assets to pay off the bonds.

If you follow this strategy, you can find bonds that will pay you 6 to 8 per cent annually for two to three years as you wait. Typically in the third or fourth year, the company sells assets (or refinances) and buys, or "calls," the bonds. If this happens, you pick up 2 to 4 per cent more in capital gains. Or, the bonds may simply float up as refinancing nears.

Occasionally the Canadian market offers such bonds at bargain prices. During the credit crunch a couple of years ago, bonds from Air Canada and Celestica were available for a song. But in general, more of these tempting investments are available in the U.S.

What to look for? Beyond sufficient cash flow coverage, what you are really after is good assets that a company can sell, or refinance if need be, to pay off the bonds. If you have free time and like sleuthing, you can do the work yourself. But if you do it inside your RRSP, there are drawbacks.

First, it is real work. You must research the company's assets - preferably with real physical inspections - and that takes time. Second, you cannot hedge your currency risk inside an RRSP.

That's why I generally recommend that people invest in a fund that can do the hard work for them. Look for a fund that hedges its currency risk and buys shorter-term bonds. Also look for a fund in which the same portfolio manager invests both in bonds and equities, because the deep due diligence involved in investigating assets is the kind of research that equity investors are more likely to do than bond investors.

A fund can also use borrowed money to lever up your investment. One strategy is to use the borrowed money to buttress the bond holdings with high-quality, dividend-paying stocks. Their dividends can enhance the yield and can also result in additional gains if the stock prices rise.

As for stock trading by itself, I would avoid doing it in your RRSP past middle age. When I was in my thirties, I used to trade inside my RRSP and had the misfortune of being lucky one year. As a result, I took even bigger risks the next year, and my RRSP gave back almost all the previous gains. The result was a two-year average return of barely 6 per cent, which was certainly not worth the time that I was spending on the trading.

My experience taught me a lesson. Risky investments are for outside your RRSP, where losses are tax-deductible. Inside it, go for the steady gains - especially when your hair starts going grey.

The Globe and Mail


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