Bullish on Energy? Find Safety in Canadian Short Term Debt

Almost like clockwork the commodity market tree was shaken pretty hard by the arguments that China would have a hard landing. In fact the day after my article on copper was posted copper prices fell over 3 percent. The two best-of-breed copper companies Southern Copper (SCCO) and Freeport- McMoRan (FCX) were sold off between 5 and 10 percent, respectively. Meanwhile from Jan 19 (the day the article was posted) until now, copper prices have not only rebounded; they are even higher than when my article was posted. Yet these stocks remain off of their highs. I only point this out because it proves my point that with so much macroeconomic risk present commodity stocks generally, and copper specifically, are prone to extremely high bouts of volatility, which can be used to purchase these stocks on significant short term corrections. However, the long term bullish fundamentals for copper remain intact and as Dennis Gartman would say, “the trend is from the lower left to the upper right,” thus it is still prudent to err on the side of bullishness in the face of short term corrections.

So as most people are aware, North Africa has become the apex of uncertainty for the moment. While many analysts are scratching their heads with curiosity, the seemingly more knowledgeable people are very quick to point out that in reality no one really knows what is going to happen. They have also pointed out that it may be months and even years before the dust settles and we get a clear picture or any sort of resolution. One short term implication of the unrest so far has been energy prices rising sharply amid all the chaos. As far as I am aware there have not been any actual sizable supply disruptions in production or shipping and many analysts including the IEA have said that Egypt is not causing an energy crisis. From a North American perspective there is still plenty of opportunity to earn a compelling return for a modest amount of risk that may actually reduce overall portfolio risk while still implicitly remaining bullish on a safe secure vast amount of energy resources that feed the US.

On Jan 19, I posted an article pertaining to three reasons I wish to stay bullish on Canada. The three primary reasons I listed in my article on Canada were:

1. A superb central bank that has so far shown itself to manage the economy quite well,
2. Regulators (incl. the Central Bank) that have both hands on the wheel and both eyes on the road with respect to the housing sector, and
3. The vast natural resources in Canada are in, and will likely remain in, robust demand long into the future.

In light of how the market has turned quite bullish on energy amid fear of some sort of supply shock either in the Suez Canal or potentially a new Iran in the Middle East, I would encourage investors to look to our (the US’s) friends to the North for potential opportunities. They actually supply more crude oil to the US than any other country and that fact is not likely to change in the near future. In fact, billions of dollars of capital investments among integrated oil companies are being poured into infrastructure to increase imports of more Canadian crude oil in the future. Quite simply, the long term fundamentals remain quite bullish on Canada. Having said that, There is more than one way to skin a cat, and as such there is more than one way to play the Canadian theme.

One particular way to play the Canada bull theme that may be very compelling for US investors is to buy short term Canadian debt denominated in Canadian dollars. On more than 9 years the I-Shares DEX Short Term Bond Index Fund (TSE:XSB) listed on the Toronto stock exchange has been - and I believe will be - a great investment, from a US investor perspective, into the future.

XSB seeks to provide income by replicating, to the extent possible, the performance of the DEX Short Term Bond Index, net of expenses. The DEX Short Term Bond Index is a market capitalization weighted index consisting of a broadly diversified range of investment grade federal, provincial and municipal and corporate bonds with a term to maturity between one and five years.

Some portfolio characteristics, which are on the I-Shares Canada website, are shown below:

An extremely important, albeit frequently overlooked, question individual investors forget to ask is “how does this investment behave in the context of my overall portfolio?” For an investor who is predominately holding US equities assumed to be equal to the S&P 500, this investment strategy would have worked beautifully over the past 9 years. Here are some of the crucial portfolio characteristics in the context of a portfolio that is weighted 100% to the S&P 500.

*These metrics are constructed factoring in the change in the CAD/USD exchange rate as well as the price (including dividends re-invested) of XSB.

From a US investor perspective, the volatility of XSB is lower than the S&P 500 which to a large extent should be expected of a short term bond fund. The average annualized return has been substantially higher than the S&P 500 (which can be attributed to a significant appreciation of the Canadian dollar as well as strong performance of short term debt). The correlation between XSB and the S&P 500 (as measured by SPY) is essentially non-existent to negative at best. With a correlation to SPY of zero to very slightly negative, an allocation to XSB stands to reduce overall portfolio risk for a portfolio highly correlated to SPY. In terms of risk reward which is often measured by the Sharpe ratio of an investment, XSB has been spanking SPY for the last 9 years. Even if you measure the Sharpe ratio from January 2009 until December 2010, XSB is still beating the S&P 500 on a risk/reward basis–despite the S&P 500 appreciating nearly 50 percent.

Many people, including myself, believe that interest will likely be higher than they are right now at some point in the future (i.e. 5+ years). The only people that seem to argue interest rates will remain low seem to only disagree on the timing not actually direction. Thus it is important to think about how XSB might perform through a period of rising interest rates.

Despite the fact that XSB is a bond fund, it will probably perform pretty well into the future, even during a period of rising interest rates. Recall that XSB is actually a short term bond fund which means they are not locked into long term bonds that will see significant price declines in the face of short term interest rate hikes. Moreover, the yield on XSB will track upward along side short term rates (albeit not necessarily on 1:1 basis).

Had you invested $10,000/USD into XSB in December 2001, your investment would have fared just fine from 2002-2007 (a period of rising short term interest rates). Today that same investment would be worth $20,178/USD. While history is not necessarily indicative of the future, I don’t see any particular reason that XSB will perform differently the next time around but I welcome opposing views for consideration.

My take: from a US investor perspective, XSB might be a very compelling opportunity to include into your portfolio. XSB stands to reduce risk while enhancing returns. I believe it will perform well even against a backdrop of all-time low interest rates and in fact provides some amount of “flight to safety” insurance for the times when investors panic and flock to short term debt. Thus, if you are looking for ways to take advantage of compelling risk/reward opportunities while taking a constructive view on Canada and implicitly on energy, while reducing exposure to the US Dollar, XSB might be a great option for your portfolio.

Good luck and thanks for reading.

Disclosure: I am long FCX, SCCO, EWC, TBF.