(For more explanation on how a MIC works and the general application of a MIC in a balanced portfolio, please see my column available exclusively in the print and digital editions of MoneySense magazine.)

Of course market veterans are quick to point out that with great reward comes great risk. Considering the stagnant stalwarts of fixed income—GICs and government bonds—are struggling to offer investors a rate of return of at least 1.5%, wouldn’t that put MICs in the great risk category? Not when you consider the underlying assets. Because MICs must keep 50% of their holdings in mortgages backed by residential real property (or in CDIC-insured holdings), the majority of risk revolves around residential mortgage default rate—a rate that is notoriously low in Canada.

“Even in the 1990s, when the Canadian real estate market crashed, the default rate for residential mortgages never climbed higher than 0.66%,” explains Jane Knop, the Harvard-educated managing director for First Swiss AM, a Toronto-based MIC that specializes in residential first and second mortgages. Compare this to the average default rate of North American corporate bonds—which sits at 1.01% between 1982 and 2010.

Examime the risks

With apparently lower risk and higher returns, does this mean you should liquidate your fixed income holdings and plow the money into MICs? Not necessarily.

The truth is not all MICs are created equal. While all are legally mandated to keep 50% of their investments in residential mortgages, what constitutes as a residential mortgage can be quite broad—and this can seriously impact the level of risk and volatility of a MIC’s investment portfolio.

For instance, residential debt can include first and second mortgages. If you hold a first mortgage you have priority if a default occurs. This makes second mortgages more profitable, but much riskier.

Residential debt can also include construction loans or bridge financing for residential new-builds or repairs—a much riskier form of debt given its commercial nature. (Although, the debt is still considered residential under the Income Tax Act.)

Other risk factors include:

• A high loan to value on any one property;
• Whether or not the MIC is too geographically concentrated. For instance, if all loans are in Northern Alberta, these loans could be seriously impeded if oil commodity prices drop and homeowners are left unemployed and forced into foreclosure;
• If a MIC is highly leveraged this may be a bad sign. That doesn’t mean MICs with lines of credit or that use leverage are poor investment choices. In fact, a MIC that doesn’t have access to a line of credit or excess capital can actually be worse, but you don’t want to invest in a MIC that’s boosting their returns through leverage. The returns should come from their portfolio of holdings, and the leverage used to establish solid holdings for long-term performance;
• Whether or not the MIC has policies limiting the maximum percentage or total dollar amount that can be invested in any one mortgage or borrower.

Evaluating those risks

“It’s about due diligence,” explains D.G. Southen—a London, Ont.-based real estate investor who started with bricks and mortar holdings and added MICs to his portfolio just over two decades ago.

But just like buying a corporate bond or a sector ETF or mutual fund, the more you know about the underlying asset, the better you can asses the level of risk associated with the investment. When evaluating a MIC, make sure you examine the underlying portfolio of debts. This analysis should include:

• A list of addresses where mortgages are held;
• The property values and their loan values on each address (or sector, at the very least);
• And the purpose of the loan—is it for construction, will it be used as a bridge loan, is it to establish future income-producing cash flow. Also, verify whether the mortgages are first or second mortgages. While you’ll get the opportunity of a greater return on a second mortgage, you’re also adding much more risk.

You should also ask to see independently audited financial statements as well as the MIC’s dividend statement—the annualized net returns offered by the MIC since inception.

In the end, though, what you’re really buying is the manager’s performance, says Michael Nisker, managing partner of Trez Capital, a firm that offers only a handful of publicly-traded MICs on the TSX. “In that respect, you need to answer two questions: What is their record? And how long does that record continue?” Consistent returns—not one year high and the next low—with a close to zero loan loss for a decade or more shows a well-run book of business.

It was this due diligence that enabled Southen to earn a 12% annualized rate of return over the last 22 years. “I have not held a common share in my RRSP since 1991,” says Southen. “The reason? I make more money with debt investments than I ever would with common shares.”

Keeping it tax efficient

For those interested in MICs, be aware that you don’t make money on the appreciation of the shares you own. Instead, you earn a dividend-like payout every month (or quarter or year) based on the interest collected from the pool of mortgages owned by the MIC. The more shares you own the larger the payout, which is taxed at your top tax rate as interest income.

To minimize the taxes you pay look for corporations that offer holdings in registered savings plans, such as an RRSP, TFSA, RRIF, RESP, RDSP, among others.

To keep your MIC holdings in a registered plan you’ll need to pay the corporation administration fees, and some are definitely more economical than others. Typical costs for an RRSP holding range between $100 to $150 per year, while an RESP or a TFSA holding will cost you $25 to $75 per year in administrative fees.

Also, keep an eye out for set-up, closing and redemption fees—you’ll want to know these up-front so you can factor in these costs for entering and exiting the investment.

Will you get double-digit returns?

Finally, don’t be surprised if MIC returns have—or continue—to drop. At present, most stable MICs are providing a net 5% to 10% return to their investors, depending on the risk level. “There’s more capital competing for the good, quality debts and that pushes rates down,” which impacts returns, explains Knop. This may change as more individuals and businesses find it difficult to qualify for mortgages, but for now, even MIC returns are feeling the pinch. That is if you consider a 5% to 10% annual return on a fixed income investment pinched.

Where to find a MIC

Finally, if you’re really interested in MICs you’ll need to do a bit of your own research. For those interested in private placement MICs—corporations that sell shares through Offering Memorandum, you’ll need to do a search. There are hundreds of MICs in Canada—some large and some small. For accredited investors, there is ample choice and MICs can be found operating in almost every province, but you’ll need to really examine the investor materials provided. Remember you’re looking for consistency, longevity and a lower risk profile for sustained returns.

For non-accredited investors, or investors with a lower minimum sum to invest, consider publicly-traded MICs. Up until 2011 you really had only three options to choose from. However in the last year, the number of publicly-traded MICs on the TSX has risen to about a dozen. The advantages of these market-traded MICs are as follows:

• No minimum investment or accredited investor requirements;
• Better liquidity;
• Potentially better disclosure by virtue of it being a listed, public company;

Current list of publicly-traded MICs (in alphabetical order):

Atrium Mortgage Investment Corp. (TSX: AI)

Mandate: One or two year terms with 85% first mortgages an 15% second mortgages on income-producing residential real estate, with 65% in residential and 35% in commercial residential.

Weighted average loan-to-value of mortgage portfolio is 66.7%

Current Yield: 7.35%

Distributions: Monthly

Fees: Not apparent

Eclipse Residential Mortgage Investment Corp. (TSX: ERM)

Mandate: Single family residential mortgages

Current Yield: 6% to commence after anticipated closing date of June 28, 2013

Distributions: Monthly

Fees: Not apparent

Firm Capital Mortgage Investment Corp. (TSX: FC)

Mandate: Mostly conventional first mortgages in Ontario

Current Yield: 7.64%

Distributions: Monthly

Fees: Management fee of 0.75%; mortgage banker fee of 0.1%; performance fees charged on mezzanine and equity investments

First National Mortgage Investment Fund (TSX: FNM.UN)

Mandate: Single-family residential mortgages and multi-unit residential and commercial mortgages across Canada

Current Yield: 6.56%

Distributions: Monthly

Fees: Management fee of 1.35%; performance fee of 0.20% over hurdle rate (hurdle rate based on 2-year GOC bond yield plus 4%)

MCAN Mortgage Corp. (TSX: MKP)

Mandate: Uninsured single-family mortgages and residential construction loans with core markets in Alberta, Ontario and B.C.

Current Yield: 6.86% ($1.42/share)

Distributions: Quarterly

Fees: $0.04/share

ROI Canadian High Income Mortgage Fund (TSX: RIH)

Mandate: Commercial mortgages

Current Yield: 6 %

Distributions: Monthly

Fees: Not apparent

ROI Canadian Mortgage Income Fund (TSX: RIL)

Mandate: Commercial mortgages

Current Yield: 5.04%

Distributions: Monthly

Fees: Not apparent

ROI Canadian Real Estate Fund (TSX: RIR)

Mandate: Commercial mortgages

Current Yield: 6%

Distributions: Monthly

Fees: Not apparent

Timbercreek Mortgage Investment Corp. (TSX: TMC)

Mandate: Primarily residential and retail mortgages in Ontario, Alberta and Quebec. No leverage

Current Yield: 7.79%

Distributions: Monthly

Fees: Management fee of 1.2% per year

Hurdle rate: 2-year Government of Canada Bond Yield plus 4.5%

Timbercreek Senior Mortgage Investment Corp.(TSX: MTG)

Mandate: Shorter-term first mortgages (or customized first mortgages) in residential and multi-residential, as well as office, retail and industrial properties located in large urban markets

Current Yield: 6%

Distributions: Monthly

Fees: Management fee of 1.0%

Hurdle rate: 2-year Government of Canada Bond Yield plus 3.5%

TREZ Capital Senior Mortgage Investment Corp.(TSX: TZS)

Mandate: 50% in residential and the remainder in office and retail mortgages. Loan terms up to 36 months with a concentration in Ontario, Alberta and B.C. (but some holdings in Saskatchewan and Nova Scotia)

Current Yield: 5.0%

Distributions: Monthly

Fees: Not apparent.

Hurdle rate: 5% over GOC bonds

TREZ Capital Mortgage Investment Corp. (TSX: TZZ)

Mandate: 50% in residential, 40% in office and remainder in industrial and retail. Loan terms up to 36 months with a concentration in Alberta and Ontario, but with holdings in New Brunswick, Nova Scotia, Quebec, B.C. and Saskatchewan

Current Yield: 7% to 9%

Distributions: Monthly

Fees: Not apparent.

Hurdle rate: 5% over GOC bonds

*Prices as of May 10, 2013.

Croot and Carey paid off their 25-year mortgage in 2002, 10 years earlier than expected. With the freed-up income, they were finally in a position to focus solely on building up their retirement savings—and that’s exactly what they did, continuing on with their regular jobs for three years prior to moving to Port Hope. These days, Phil is retired from his engineering career, while Heidi has transitioned to part-time work. Their only regret is that they didn’t figure out how to do this earlier.

As the couple will attest, paying off your mortgage is the single most important step towards financial independence and a prosperous retirement. Owning a principal residence outright gives you the financial freedom to funnel money that formerly went to your mortgage into your savings or to pursue lifelong dreams like travelling. Don’t forget, too, that mortgage interest adds tens of thousands of dollars to the real cost of a home, so a shorter mortgage slashes the amount you pay in total. Paying off your mortgage as quickly as possible should therefore be an important goal for any homeowner—whether you’re halfway through the process, just starting out, or even just contemplating buying a house.

If all the above advantages sound compelling, bear in mind that sacrifices will have to be made. “Paying off the mortgage early wasn’t easy,” Croot says. “We had friends who were going out twice a week for dinner and we didn’t do that.” Without question, tightening up your spending is a key tactic for freeing yourself from mortgage debt, but there are also many other strategies that won’t cost you a dime and can save you thousands. Allow us to let you in on the secrets every prospective and current home owner should know.

Polish off your credit score

If you’ve always paid off your debt in a timely manner, your credit score should be fine. But that doesn’t mean you couldn’t have any unexpected surprises, says Toronto fee-only adviser Jason Heath. He cites the example of a client who was buying a condo and was unaware she had $300 outstanding on a Holt Renfrew card. It took her more than three months to repair her credit rating. While that single infraction wouldn’t have been enough for a bank to deny her a mortgage, it could have resulted in a significant jump in her interest rate.

Moshe Milevsky, an author and finance professor at the Schulich School of Business, says people applying for mortgages should pull their credit scores six to 12 months in advance to make sure there’s nothing wrong. “Get your credit report from all the bureaus,” he advises. Also, try to avoid job volatility for at least six months before applying, as this will make your income appear more stable in the eyes of the banks.

Maximize your down payment

While all home mortgages in Canada require a minimum 5% down payment, paying 20% upfront is one of the single biggest cost-cutting measures a borrower can make. Not only will you owe the bank less principal and interest, but critically you will avoid having to pay Canada Mortgage and Housing Corporation (CMHC) insurance premiums that would add thousands of dollars to your mortgage. CMHC mortgage loan insurance doesn’t protect you—it protects your bank if you default. It’s mandatory in Canada for down payments from 5% to 19.99%. (This insurance can also be purchased through Genworth, a private company.) And the cost is substantial—for instance, if you only put a 5% down payment on a $350,000 home, the CMHC premium will be a hefty $9,144.

If you can’t afford an initial payment of 20%, putting down 10% to 15% will still reap major financial savings. “Those are the insurer breakpoints where insurance fees drop,” says Vancouver mortgage broker Rob McLister. “For example, putting down 10% instead of 9.9% saves you 0.75 percentage points off your entire mortgage amount. That’s $1,500 on a $200,000 mortgage.” For those looking to boost their down payments, the Home Buyers’ Plan is a popular option; it lets you withdraw up to $25,000 in a calendar year from an RRSP to put toward a home you are buying (or building).

One of the best strategies for avoiding mortgage default insurance premiums—and to get into the market sooner—is to buy a house that fits your budget. “Sometimes you can’t move into your dream house as quickly as you want,” says Jason Heath. “But with a smaller property you’re that much closer to having that 20% down payment, not to mention money left over.” That was the strategy Anne Langevin, a 43-year-old retail clerk, and her husband Rene, a 42-year-old finance manager, followed back in 1998 when they bought a $210,000 suburban starter home in Mississauga, Ont. “It was just the two of us and the house was reasonable. It wasn’t a huge mansion,” says Anne.

Get the best rate

Prospective home buyers often stick with their own financial institutions when applying for mortgages, but it pays to shop around. Credit unions and non-direct lenders, known as monolenders, will offer a discount—sometimes just a fraction of a percentage point—that will save you money on interest payments compared to larger lenders. For those worried about getting mortgages from more obscure companies, Heath says to remember you’re borrowing, not investing. “The fact it’s a more obscure institution makes it no riskier than a bank. You’ve already got the money.”

Heath recommends scanning the major rate comparison websites—such as Ratesupermarket.ca or Ratehub.ca—to get a general sense of where the market is. Also be sure to ask your lending institution if the interest on your mortgage will be compounded monthly or semi-annually. The less often the interest is compounded the better—semi-annual compounding could save you hundreds of dollars or more in interest.

If you’re not comfortable negotiating on your own, a mortgage broker will do that on your behalf for free. Mortgage brokers are paid a finder’s fee by the lender. There’s no charge for a pre-approval and no obligation. “We’ve always used mortgage brokers,” says Anne Langevin. “When you go into a bank you have to haggle for a lower rate. My husband and I don’t like to haggle.”

Normally variable-rate mortgages are a better deal than fixed-rate mortgages because you pay a premium for the security of locking into a rate. However, that doesn’t appear to be the case right now, says Jason Heath. “Fixed and variable rates have almost been identical for five years—2.9% on fixed and 2.8% on variable,” he says. “So, arguably the cost of locking into a fixed-rate mortgage is so cheap that it’s more compelling to do so.”

Watch the fine print

Securing a low interest rate can shave years off a mortgage, but equally important are the terms of your contract. “Not looking into that and just going by the rate can get you into trouble,” says Calgary mortgage broker Joe Jacobs. For instance, when the Bank of Montreal was the first major lender to drop its five-year lending rate to 2.99% early in 2012, you couldn’t break the mortgage to switch to another lender. “That’s a fairly significant thing,” says Jacobs, “but a lot of clients didn’t know what that was.”

This is where experienced mortgage brokers can make a difference, he says. They will review any restrictions or potential penalties on the mortgage that may end up costing you far more than a small rate difference.

Prepayment privileges also go a long way toward helping pay off a mortgage faster. It may seem unfair, but most mortgages limit your ability to pay off your debt early because the financial institutions will lose the interest revenue that they were expecting. Most mortgages allow borrowers to make annual prepayments of 10% to 20% of principal, without extra fees, with the increased payment amount going directly towards the principal. Just be sure to inquire about the details, as some “no frills” mortgages may prohibit this option. Also be aware that payout penalties—the fees you’ll pay if you break your mortgage early—can sometimes cost tens of thousands of dollars.

The right amortization

Those who want to pay off their mortgages sooner should choose the shortest possible amortization within their financial means, or, as Moshe Milevsky, puts its: “as short as possible until it hurts.” While the typical amortization period is 25 years, it can be as short as 15 years, or as long as 35 years (if you made a down payment of 20% or more on your home). Forcing yourself to pay off the mortgage in fewer years translates into lower interest costs and substantial savings. The major hitch, however, is that your regular payments will be much higher.

To give yourself the best of both worlds, Vancouver mortgage broker Mark Fidgett advises going with a longer amortization, but setting your regular payments higher with prepayment privileges. In effect, you could be paying off a 20-year mortgage in 10 years, but you’d also have the flexibility to switch back to smaller installments if you were to experience any changes like a job loss or the birth of a child. “That way, you’re in control,” says Fidgett. Your payment schedule can also make a big difference. Payments can be made every month, twice a month, every two weeks or weekly. Going with one of the latter two options is preferable because it will accelerate your payments by an additional two weeks every year. For instance, over a 25-year amortization period on a $350,000 home with a 3% rate you would save more than $18,000 in interest by going with an accelerated biweekly plan.

Prioritize your mortgage

Maximizing your down payment and procuring the best rate and terms possible will save you thousands of dollars. But extra payments will have the biggest impact. To do that, you’ll have to make some tough decisions about your spending and cut out non-essential items, such as family vacations and other luxuries. You may need to stop saving for retirement, depending how serious you are about being free of your mortgage. While that may seem extreme, those who free up their home debt quickly can easily make up for lost investment time later on, provided they funnel cash that previously went to their mortgage into retirement savings.

Remember that paying off debt has the same impact as saving, as both add to your net worth. However, most people’s retirement money is in investments that may or may not gain value, while money paid against the mortgage gives you a guaranteed return by saving you interest.

Nicholas Hui, an auto parts salesman, and his wife Kathy Chan, a law firm marketing manager, followed this strategy, paying off their $434,000 mortgage on their Markham, Ont. home in six years. “We didn’t have extravagant lifestyles,” he says. “We didn’t go to Europe or anything.” Instead, they opted for an open mortgage, which has a higher interest rate but no penalty for making extra payments. Several years of sacrifice and a few $20,000 and $30,000 lump-sum payments helped them meet their goal. These days, they’re quickly catching up on their RRSPs and have started RESPs for their young children—all without the burden of a large mortgage hanging over their heads.

The real key to paying off your home faster is to make sure you get a mortgage that allows you to make extra payments throughout the year and take advantage of them. “That’s the most likely way you’re going to pay off your mortgage a bit quicker,” says Heath. He says borrowers are less likely to make extra payments if they are only allowed to make a single lump-sum contribution on an anniversary date.

Another strategy for paying off your mortgage faster is to increase your regular payments to the maximum allowed without penalty, typically 10% to 15%. Some mortgage contracts also allow borrowers to double their payments. That was one of the strategies Anne and Rene Langevin used to pay off their $210,000 home in less than five years. In addition to making prepayments of 15% to 20% annually, says Anne, “we doubled-up payments whenever we could.”

Paying off your mortgage early isn’t easy, but you’ll thank yourself for it later on. Back in Port Hope, Heidi Croot and Phil Carey are living proof. These days, the couple enjoy living debt-free in their country home, which sits on seven acres of lush property in Ontario’s Northumberland County Forest. Although the two have socked away a nice chunk of money for retirement, Croot still enjoys working part-time to earn additional income—but at a far more relaxed pace. Budget vacations have long since been done away with, too. “We take more expensive ones now,” says Croot. “Africa is on the horizon. We did Maui last November.” All the sacrifices the couple made years ago to free themselves of mortgage debt have paid off. As Croot puts it, “It’s good to be alive and in the driver’s seat.”

Don’t spend money you haven’t earned yet. If you let yourself get distracted by new and shiny as your parents have, you’ll end up carrying a whack load of consumer debt just like mommy and daddy. Show you have some self-control. Demonstrate that you know how to prioritize. Live within your means.

Your income and your stuff don’t say jack about you. My generation has bought into the branding tomfoolery like no generation before. If you define yourself by the labels you wear, by the model of the car you drive or the amount of money you make, you’re walking in the wrong footsteps. Let’s face it, a guy who makes $100,000 a year selling stuff people don’t need isn’t a better person than the guy who makes $35,000 helping an autistic child integrate into a classroom and learn to socialize. Your actions define who you are.

How much you make doesn’t matter as much as what you do with your income. Sure, you may not make bundles of money, but if you can live a worthwhile life and make your money do what you need it to do, you’re way smarter than the Ritchie Rich with the flashy lifestyle and debt-rot at the root of his financial foundation. Live a real life and keep track of every penny.

Watch who you choose for your peer group. Once upon a time we measured ourselves against our family, friends and neighbours. (Hey, you can say we shouldn’t measure ourselves against anyone, but that’s just not reality!) My generation decided to measure how we’re doing against the people we see on TV and in magazines.  If there were no décor-porn, we’d all feel a little less like our homes constantly need upgrading. You don’t need granite counter-tops to turn out healthy and delicious meals for the family. Build a life of substance and focus on what’s really important: stability, happiness and a sense of belonging.

]]> http://www.moneysense.ca/2013/06/17/investing-in-2013/feed/ 0 http://www.moneysense.ca/2013/06/17/etf-investors-avoid-the-after-hours-club/ http://www.moneysense.ca/2013/06/17/etf-investors-avoid-the-after-hours-club/#comments Mon, 17 Jun 2013 12:00:51 +0000 Canadian Couch Potato http://canadiancouchpotato.com/?p=6879 One of the first rules of buying and selling ETFs is to always use limit orders, never market orders. A limit order allows you to specify the maximum price you’re willing to pay, or the minimum you’re willing to accept. By setting this limit a couple of cents above the ask or below the bid you ensure you won’t be surprised by a sharp move in the markets or a pricing anomaly.

That message seems to well understood, but a related issue has come up a few times with clients of our DIY Investor Service. We’ll be working with a client who has a nine-to-five job, and when it comes time to implement the portfolio he’ll ask whether we can make the trades in the evening, after the markets have closed. Wouldn’t the orders just be filled the next day after the opening bell, he’ll ask? They might, but you may not like the results.

Prices that go bump in the night

It’s quite common for companies and governments to make important announcements in the pre-market or after hours, which may causes price of securities to open sharply higher or lower than their previous closing price. When that happens, market orders could get filled at a price much higher or lower than you expected. And even though limit orders are safer, they may go unfilled if an ETF’s price opens well above or below its previous close.

International equity ETFs can be especially vulnerable, since their domestic markets are open when North American exchanges are not. When the opening bell rings in Toronto or New York, market makers need to update prices based on what happened during the night.

And as I’ve discussed before, an ETF’s market price will occasionally diverge from its net asset value. This is most likely to cause problems in the first few minutes after markets open and the last few minutes before they close. If you place an order after regular trading hours it will be executed as soon as the market opens the following day, exactly when the likelihood of a price distortion is highest.

The Toronto and New York stock exchanges are open on weekdays between 9:30 a.m. and 4 p.m. Eastern Time, which admittedly can create a narrow window for those in other time zones. If you live in British Columbia, the markets close at 1 p.m. local time, while Nova Scotians can’t place a trade until 10:30 a.m. But even if these times are inconvenient, ETF investors should make an effort to work within them—or they may wake up to an unpleasant surprise.