Monthly Review - April 2012

April saw relatively little change in the value of the portfolio with small declines in the value of equities and commodities being partially offset by the cash flow from the properties. FX movements were negligible. Savings for the month were also trivial due to a combination of low income and spending on a family holiday.

Here are the details:

1. my Hong Kong equity portfolio fell slightly. I purchased shares in Fairwood, Cosco Pacific and NWS Holdings. I sold my small position in Tai Sang Land;

2. my AU/NZ equities were marginally higher;

3.my ETFs fell in slightly line with the local markets, with all being negative;

4. my commodities fell slightly, led by silver;

5. all of my properties were occupied with all tenants paying on time. There were no repair bills at all this month (although I will have a couple of minor ones in May);

6. currency movements were almost non-existent, as the NZD and AUD were flat against the HKD/USD;

7. my position in bonds remains small. No bonds were purchased this month. I would like to add some more bonds to the portfolio but am finding direct purchases of bonds through the banks I have accounts with to be something of an exercise in frustration in Hong Kong;

8. I had no open derivative positions;

9. savings were very minor due to a combination of low income (April is usually the second lowest month of the year) and high expenses (paying for the balance of our annual holiday in April and the premium on our annual medical insurance which ended up hitting the bank account in April instead of March as I had anticipated).

My cash position declined due slightly to new investments. I currently hold 48.5 months of expenses in HKD cash or equivalents. This is more than enough - in fact it is too high given current inflation levels and the near zero nominal yields on bank deposits.

For the month, my net worth fell by 0.2%. The year to date increase is 13.75%. The year is off to a good start and I remain on track to retire at the end of 2012.

Fairwood purchased

Today I added a few more shares to my position in Fairwood Holding (HK:52). The fast food company has done a good job in expanding at a sensible pace in the face of rising rents and rising labour costs. The shares offer a trailing yield of 5.5% which is attractive and, I hope, something that has the potential to grow over time.

I paid HK$13.10 for the additional shares.

Book Review: The Power of Habit

It has often been said that we are all creatures of habit. Charles Duhigg's book "The Power of Habit: Why we do what we do in life and business" explores the nature of our habits, the benefits and problems with habits and how to either change or develop them.

He begins by exploring how habits work in individuals and why they can be good things in that habits enable us to get things done with minimal effort. He then looks at how people can go about creating new habits or changing old ones. It was this part of the book which I found to be both most interesting and practical. The explanation of how the "cue - habit - reward" loop works on the brain and case studies on techniques to break it was clear, easy to follow and practical. I ended up taking a look at some of my own habits (bad ones according to mrs traineeinvestor), picked one and am attempting to use what I picked up in this book to change it. The possibilities of helping my children to form better habits has also occurred to me.

The second part of the book looks at the habits of organisations including case studies from Alcoa and Starbucks. These were interesting but of less practical use given the proximity off my retirement.

Part three looks at changes in society, drawing on examples from the civil rights movement and an American church group. It also considers the question of free will and personal responsibility for our habits.

The apendix entitled "a reader's guide to using these ideas" was useful but didn't really add anything to what had been covered in part one.

Overall, I found The Power of Habit to be one of the best self help books I have read. Highly recommended.

Cosco Pacifc purchased

In an effort to "buy the dips" and reduce the amount of cash being held, I put in a few orders to buy small quantities of additional shares in some of the companies already in the portfolio at below the prevailing market prices. This afternoon, I got hit on one of those orders and purchased some additional shares in COSCO Pacific (HK:1199) at $11.10 per share.

Having gone through the most recent result, I am happy holding this company for the longer term.

Tai Sang Land sold/NWS Holdings purchased

As part of my efforts to remove "too small to justify the time spent on them" positions from the portfolio, I have sold my shares in Tai Sang Land (HK:89) for HK$3.00 per share. While Tai Sang Land still sells at a substantial discount to NAV (as do most property companies in Hong Kong), I couldn't see myself adding to the position and decided  to sell. I took a loss of 8% (net of expenses and dividends) on the investment.

The sale proceeds have been reinvested in NWS Holdings Limited (HK:659) which is now one of my top ten shareholdings. I paid HK$11.70 for the additional shares.

Risks of not making early mortgage payments #2

As a follow up to my recent post on the risks of not making early mortgage repayments I ran a more detailed sensitivity analysis and came away with the following:

• the Hong Kong investment properties will still be cash flow positive if rents drop by up to 14%
• the Hong Kong investment properties will still be cash flow positive if interest rates increase from the current average of around 1% pa to around 3% pa

The analysis assumed a standard 12% allowance for repairs, maintenance and vacancies. In a downturn I would expect vacancies to increase. I ignored taxes.

These numbers were run as at end of April 2012.

One mortgage will come to the end of its natural life in mid 2013. At that time the sensitivity looks like this:

• the Hong Kong investment properties will be cash flow positive if rents drop by up to 23%
• the Hong Kong investment properties will be cash flow positive if interest rates increase from the current average of around 1% pa to around 4.3% pa

Of course the sensitivity to rising interest rates will decline by a small amount each month as more principle is paid off and cash flow sensitivity will take a jump each time a mortgage is fully paid off.

I have ignored the impact of rising interest rates on the mortgage on our home and the positive cash flow from the debt free properties outside Hong Kong.

Given the above analysis, other assets, cash on hand and the ability to cut household expenses if the need arises, I am no unduly worried about cash flow on the Hong Kong investment properties going forward.

Famous last words, I am sure.

Hong Kong to issue more iBonds

While the Hong Kong government's plan to launch a second issue of iBonds in June is not exactly news, the upcoming issue has generated some recent debate in the media with views ranging from "it's the best free lunch on offer" to "they are a cynical political tool and a lousy investment".

While the iBonds are touted as bonds designed to protect investors from inflation, this is grossly misleading - they will do nothing of the sort. In the first place, there is no adjustment to the principal - you subscribe at face value and redeem at face value. Second, the coupon is linked to HK CPI - there is no premium over CPI to offer a "real" yield and, in fact, the yield is guaranteed to be less than CPI becuse (i) it is a trailing yield and (ii) bank charges on each coupon payment will have to be paid. Even this assumes that you believe that CPI is a realistic proxy for household inflation (not even close in my household). The floor of 1% is noted but I would be surprised if inflation dropped below 1%.

So why buy an investment that offers a guaranteed negative real return?

The investment rational is that I will be keeping a reasonable amount of money in the form of cash or near cash as I enter retirement (at least two year's worth of expenses). This asset allocation is all about reducing risk rather than maximising returns. While the returns on the iBonds are poor, they are better than anything else I can get in the short term debt or deposit market without taking on FX risk or material credit risk. This makes them more or less a no brainer.

Of course, like last time allocations are expected to be limited so it will be very much a case of taking what I can get (and, no, I wont pay a premium in the secondary market).

All this assumes that the terms of the new issue are the same as the first issue - which is yet to be announced.

Risks of not making early mortgage repayments

In response to yesterday's post on when to make early mortgage repayments I received a comment pointing out the risks associated with carrying mortgages into retirement. The comment was quite on point in that stating that I was focused on the rewards and that carrying debt into retirement involved a greater degree of risk than not carrying debt. The same is true of debt at any time, but I will keep the discussion focused on the issues as they apply post retirement - that is when I no longer have employment related income to fall back on and have to meet the repayment obligations from my investments.

Interest rate risk

As is usual in Hong Kong, the interest rates on my mortgages are floating rates. All my mortgages are set at a margin over either one month or three month HIBOR. If HIBOR rises then the interest rates I pay on my mortgages also rises. If interest rates rise far enough and stay elevated for long enough, the investment properties will eventually end up with negative cash flow.

Rental income risk

The inward cash flow from the properties depends on three things: (i) the properties being occupied (ii) the amount of rent which each property earns and (iii) the tenants actually paying the rent. In adverse economic conditions the amount of rent each property can earn could decline and the vacancy factor could increase. This was certainly the experience in 2001-2003 when many landlords were forced to cut rents or accept lengthy vacancies.

Cash flow risk

The risk of a combination of rising interest rates, increased vacancies and lower rents pushing the properties into a negative cash flow situation is a very real risk. It's also worth remembering that if/when such circumstances occur, property prices will probably fall, so I have to assume that selling a property to alleviate the problem is likely to be a very unattractive option.

Inflation risk

Inflation has been higher than interest rates for several years now. As long as that situation is continues, keeping the mortgages on the properties actually reduces the risk of inflation adversely affecting my retirement plans.....right up to the point where higher inflation results in interest rates high enough to cause negative cash flow from the properties.

How big is the risk?

It has been some years since I last did a sensitivity analysis on the portfolio and I will do one at some stage before I retire. However, off the back of the envelope, I can say that the properties will still be cash flow positive:

• if any one property is permanently vacant (or the two smallest ones); or
• if vacancy rates remain the same as they have for the last few years but rents are cut by around 12%; or
• if interest rates increase to a bit over 5%.

Of course, as explained above there is a possibility of all of these things happening at once which will result in negative cash flows much sooner.

It's also worth remembering that because the mortgages are P+I, the sensitivity to rising interest rates gets reduced each month, eventually being eliminated altogether once the last mortgage is fully paid off. One mortgage will be completely paid off in mid 2013 and the last one in 2029. The biggest mortgage is the one on our home and that will be paid of in 2020. As each mortgage is paid off the debt related risk declines.

I also intend to carry a meaningful amount of cash or near cash in retirement. If necessary, this can be used to either cover a negative cash flow or make some early repayments - the amounts involved are enough to be meaningful.

There is considerable room to cut our expenses if the need arises.

I could always get a job if the need arises (as could Mrs Traineeinvestor for that matter).

In short, while the risk is quite real, it is not one that I worry about too much. It is also one that will disappear over time.

Short term risk v long term risk

The alternative to carrying mortgage debt into retirement is to pay down the debt in lieu of making other investments and/or selling assets to reduce debt. While such actions would reduce the short term financial risks, over the medium to longer term the end result would be a smaller pool of assets and a retirement that is more vulnerable to adverse events (in particular inflation).

By not making earlier repayments, I am electing to increase the near term risks in order to reduce  the longer term risks to the financial sustainability of my retirement. Given that it is easier to find well paying employment in my late forties and fifties than in my sixties or seventies, that is a trade off that I am more than willing to embrace.

I will do the sensitivity analysis but for now at least I am quite comfortable with my decision.

When to make early mortgage repayments

All our Hong Kong properties are mortgaged and will remain so when I retire. Given current market conditions, it makes no sense whatsoever to make early repayments on any of the outstanding mortgages:

• interest rates on the mortgages are currently averaging less than 1.0%
• interest expenses are tax deductible
• inflation is still above 4%
• there is no shortage of good shares with yields well above 1.0%
• the rental properties produce a positive cash flow after all expenses including the principal component of the mortgage payments
• if I had to borrow today, I would probably end up paying 2.15-2.4%

There simply isn't a case for making voluntary repayments.

However, the interest rates are HIBOR based floating rates - they get reset either every month or every three months. If HIBOR rises then the interest rate I am paying on my mortgages will also rise.  The question is, at what point should I start making additional repayments?

Without wishing to over analyse the situation, I would start making additional repayments if any of the following applied:

• interest rates were higher than the rate of inflation
• the investment properties were producing a negative cash flow
• interest rates were higher than the yield on other available investments

In each case, it would also be necessary for me to believe that the situation would continue for some time and was not a short term issue.

It also helps that all of the mortgages are P+I - each month the balance gets a little smaller even without any additional payments and, as the balances get smaller, the impact of rising interest rates becomes less significant.

Fletcher Building purchased

I have cleaned out most of the NZD/AUD which has been building up since my last purchase and invested it in shares of Fletcher Building (NZ: FBU). Fletcher Building has a degree of market dominance in New Zealand and substantive presence in Australia. The shares have recently been marked down on expectations that the company's profits will take a hit from a downturn in the Australian housing market and delays in the rebuilding of Christchurch.

The shares pay a dividend yield of about 4.5% (after netting out non-resident withholding tax) which is more than I am getting in the bank or can get on short term debt without taking undue credit risk.

I paid NZD6.27 per share.