Bonds and fixed-income securities have historically returned less than equities. But, in return, they guarantee to provide cash flow in a timely fashion if you hold them directly.
Bonds make an excellent addition to most portfolios. But to make the most of this asset class, buy them directly rather than through a mutual fund.
For more than three decades, starting in 1982, interest rates have mostly steadily fallen, providing sometimes sharp increases in the value of bonds. And consequently, bond funds have posted attractive performance records for many of those years.
In the 1990s, for example, even middle-of-the-road Canadian bond funds often boasted 10-year compound annual growth rates around 10 per cent. That compared favorably with a lot of Canadian stock funds, which often averaged less than that.
Are low interest rates here to stay?
But things have changed now that interest rates in many parts of the world are in negative territory. Some argue that today’s low rates reflect a ‘new normal’ caused by structural pressures such as aging populations, high debt loads and slow productivity growth.
The substantial drop in interest rates this year, though, raises the question whether the bond rally has gotten ahead of itself. In North America, the job market is still healthy, wages are rising and inflation remains around two per cent. If the economy proves to be stronger than expected in the months to come, then yields could significantly rise, biting into the returns of bond funds.
The slow pace of global economic growth, on the other hand, might suggest low interest rates are here to stay for awhile yet. Assuming that rates remain steady, what kind of returns can you expect from bond funds? With management expense ratios (MERs) on these offerings frequently above one per cent, the outlook is not encouraging. The current yield on a 10-year bond is now 1.45 per cent. Depending on your bond’s MER, then, there will be little or no return left over for you.
You would be better off in GICs. Using the best rates currently available, you could build a laddered portfolio with an average yield of 2.69 per cent.
Invest directly in bonds and GICs
In addition to potentially outmatching bond funds for returns, a portfolio of GICs provides another, equally important, feature—control. When you invest in a bond fund, you have no control over the maturities of bonds in the portfolio. You can’t, for example, concentrate on securities that mature when you expect to need the cash. You simply have to redeem units of your bond fund. And that can, at times, mean an actual loss. In 2013, for example, the average Canadian bond fund lost 1.1 per cent.
With high fees and loss of control for the investor, bond funds provide little more than balance, or reduced volatility, to their unit holders.
Mutual funds make excellent investments for many investors. You get professional management, diversification and administrative convenience. And yes you pay for these features. But we simply see no benefit in using mutual funds for the fixed-income portion of your portfolio. Direct investment in bonds or GICs provide a better alternative.
Build a five-year GIC ladder
Our standard advice on fixed-income securities is to build an interest-rate ladder for your holdings. Put one-fifth of your holdings in, say, a GIC that matures in one year, another fifth in one that matures in two years, and so on up to five years. Then, as a GIC matures in each year thereafter, reinvest the proceeds in a new, five-year certificate.
You’ll always reinvest at the going, five-year rate—usually higher than those for shorter terms. Plus, by restricting your fixed-income holdings to five years or less, you reduce the risk of inflation and rising rates. You’ll always have 20 per cent of your money maturing within a year.
But this approach not only reduces risk. It can also let you achieve a higher rate of return. You can currently construct a laddered GIC portfolio from our Best Rates table that has an average yield of 2.69 per cent. That exceeds the 1.45-per-cent yield you would get on a 10-year Government of Canada bond if you had enough money to get that rate.
So the result of investing for 10 years will be less return, but increased risk of inflation. And no matter what the pundits say these days, we simply have little confidence in where interest rates will be five years from now let alone 10.
This is an edited version of an article that was originally published for subscribers in the November 15, 2019, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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