Why TIPS/TIIS/Real Return Bonds Have Fallen so Much

Interesting article from morningstar explaining that hedge funds were borrowing short to buy TIPS long. So when the credit dried up, they had to sell TIPS to pay back their loans (i.e. deleverage). The consequence being that the price of the bonds really dropped. A similar phenomenon is also undoubtedly occurring with share prices.

I remember a similar thing happening to long bonds when the yield curve reversed, in the 90s I think it was. That's why I think it's better to buy bonds and hold them to maturity, especially G7 government bonds, for which the risk of default is pretty non-existent.

Bought Royal Bank @ 40 $CDN

I bought some shares of the Royal Bank a while back when they were trading at 40 $CDN on the TSX. RY also trades on the NYSE in $US.

RY fits into my strategy of buying high-yielding solid stocks to hold for 10 years or more. I'm looking for stocks with the following characteristics:

• dividend yield above 3.5% (which is a reasonable rate for inflation, not right now of course, but averaged over a long period)
• a history of dividend increases of at least 3.5%/year
• payout ratio less than 75%
• steady EPS growth over 5%/year
• ROE consistently over 15%
• 35% discount to 10 year return discounted to present value at a rate of 3.5% (inflation again).

RY meets these criteria. Nonetheless, it does hold some dodgy assets

• Auction rate securities it promised to buy back
• some sub-prime related instruments
• some credit default swaps
• and some loans to the construction industry

Added up, they amount to 9.78 billion $CDN, or 1.78$/share. (Actually, its probably more now that the CDN dollar has dropped.)

To calculate the present value of a 10 year investment in RY, I assumed that RY would have to write down 100% of the value of these dodgy assets starting in 2009. That's pretty extreme. I don't think the whole value of these instruments will evaporate. Nonetheless, it provides a conservative estimate of expected returns based on the past 10 years earnings growth. The past 10 years may have been an abnormal economic boom period so my extreme assumptions about the dodgy assets provide a bit of a counterweight. The dodgy asset write-downs would come out of retained EPS. Given the following assumptions

• Share price = 40$
• EPS growth = 17.15% (10 year rate from 1998 to 2007)
• inflation = 3.5%

Over 10 years, a 100$ investment would grow to 327$, without compounding the dividends. Given the 10 year average payout ratio of 40%, a good chunk of the gain would come in the form of dividends, which would grow at 17.15%. Using my inflation estimate to discount to present value, this represents a 132.11% gain. Viewed another way: at 40$/share, RY was trading at a 57% discount.

In contrast, using S&P500 EPS data for 1998 to 2007 from professor Shiller (thanks professor) and 848.92 as the share price, I calculated that an investment in the S&P500 would return 47.97% in present value terms. (EPS growth is a lot lower if you consider earnings for 2008, but that would include some of the financial institutions' write downs and bankruptcies so it might not be the best predictor.)

That RY is a good value is also indicated by traditional valuation measures, like dividend yield and P/E. Its 5% yield (at 40$) is much higher than its year-end yields have been in the last 10 years (ranging from 1.6%, to 3.17%). Its P/E (given by 40$ over 2007 EPS) is 10.58. The next lowest year-end P/E was 13.29 in 2000.

In terms of management effectiveness, its ROE has consistently been over 15%, and it hasn't had a negative EPS in the last 10 years.

Finally, its EPS and dividend growth have been very steady, as can be seen in the graph below.

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