Investing an Inheritance © Connolly Report April 2000 p.454

Every now and then you find another one - an article about how to invest an inheritance or some other type of windfall. I glance at such columns to see if they contain any fresh ideas: few do.
The most recent article I reviewed was in the February 18 2000 issue of Investor's Digest. I read this column more carefully because the column was written by a certified financial analyst (CFA). The subject of the column was age 50. She inherited $600,000 and wanted to supplement her income and see her capital grow (Translation: she is willing to assume some risk.). She was already in the top marginal tax bracket. I was disappointed in the ideas of the money manager: the industry line was followed.

Most of the money was put into fixed income instruments - Canada (6% Sept05), provincial (BC 7.75% Jun03 and Ontario 9% Sept04) and corporate (Domtar 10% Apr11 and Cambridge Con. 8% Mar03) bonds. If you count the Alcan E Preferred purchased for $125,000 in the fixed income category too- I would even though they were floating rate- the total allocated to fixed income was $436,000 - over 72% of the portfolio. Only three common stocks were purchased - 2000 shares each of Loblaw, Bombardier and National Bank-total $158,925. The sum of $5,000 was kept in reserve: treasury bills. The cash flow from this portfolio was $35,673. However, after tax, the income is only $19,390 - bond interest is fully taxable.

What do you think of the CFA's portfolio?
I was not impressed. Here's why:
FIXED INCOME: The client wanted to supplement her income. Bonds do provide income but the income will be static. Bonds are called fixed income instruments for a reason. The income five years out will be the same as this year: with inflation, fixed income is not good at all. There was no mention of dividend growth in the column.
LOW YIELD: The yield on Loblaw and Bombardier is less than 1%...both good stocks with excellent dividend growth records, but currently expensive: just a tiny trickle to supplement income here.
RISING RATES: The floating rate preferred was purchased "in order to take advantage of rising interest rates". However, if rates go up, the value of the $311,075 in bonds will decrease.
GUARANTEED LOSS: The unfortunate client will not get all her money back from the bonds. And they say bonds are safe. The bonds were bought at a premium, you see, to mature at par. The certified financial analyst acknowledges a built in capital loss of over $11,000 on the bonds over the next 11 years as the bonds mature.. For instance, she paid $82,125 for the 9% Ontario bonds (current yield 6%) which will be worth $75,000 at maturity in September of 2004. The CFA says "the plan is to reduce these [losses] by tax planning capital gains as an offset". Can you believe it? I've never understood why people buy bonds. At retail, bonds are not noted for their liquidity either.
SELLING PLANNED: Tax planning the capital losses on the bonds will involve selling some stock as you can only write off losses against gains. I get the feeling fees are being generated.
HIGH FEES: And speaking of fees, I would hope that the high allocation to bonds was not recommended to generate higher fees. "Bond trading is a notoriously inefficient market, allowing brokers to earn juicy margins for facilitating trades - at least with retail customers."*

What would I do? Over time, certainly not all at once, as was done here, all my inheritance would be invested in relatively high yield, quality dividend paying common stocks with good dividend growth records. This would truly supplement income for years to come: the income would grow. This person is only 50: income would need to grow. And, as the dividends increase, the capital would grow too. The portfolio needs more growth too. The client is 50.
* The Economist, Jan 15, 2000 p. 73