Bond funds lack flexibility of individual bonds

Bond funds account for about 13 per cent of the money Canadians have invested in mutual funds. But these funds do little more than enrich their managers and enslave investors.

Bonds InvestingWe recommend bonds, GICs and mortgages as suitable for any money you’ll want back in five years or less. And we recommend only the highest quality among these securities for the purpose: insured GICs and government, or high-rated corporate, bonds.

But why not bond funds? And should you hold bonds or bond funds in your long-term portfolio?

Over the last 12 months, the average Canadian fixed-income fund has gained 3.4 per cent. Over five years, the compound annual gain is 3.2 per cent.

But you shouldn’t expect similar returns over the next five years. Today, the yield on long-term government bonds is a paltry 1.48 per cent. To earn more than this, interest rates will have to fall. Yet this is by no means assured as the U.S. Federal Reserve is more inclined to raise rates than lower them, and the next move by the Bank of Canada is likely an increase in its overnight target rate. Under these circumstances, it’s possible that the drop in bond values caused by rising rates will offset the interest income from these securities, especially if rates rise rapidly. In other words, negative returns are possible in the next year or so.

With fluctuations in interest rates, you simply can’t count on a bond fund for secure income. You have no control over the bond maturities the fund holds. And bond funds do, indeed, lose money from time to time. In 1994, for example, the average Canadian bond fund lost 5.1 per cent. Some lost much more. Again, in 1999, the average fixed-income fund lost 2.6 per cent. If you needed to redeem a bond-fund investment in either of those years, you sold at a bad time.

We’re especially concerned about bond funds now that interest rates are low but are likely to move up in coming years.

So we repeat our advice. For at least five years’ income, buy high-quality fixed-income securities to mature when you need the money.

At times, you may want bonds for reasons other than income. Bonds make an excellent speculation on interest rates. As rates fall, bond prices rise. And, of course, vice versa. But even though we rarely recommend speculating on anything, some investors want bond action.

If you’re convinced interest rates will fall, you’ll want to put money into bonds of the longest possible term and with the lowest possible coupons. Bond professionals have a figure that neatly combines the two—duration. For maximum action, you’ll want bonds with the highest duration.

Control is key

As noted above, you’ll want bonds with the highest duration if you plan to speculate on falling interest rates. But again, as we said, you have no control over these characteristics when you invest in a bond fund. Only a direct purchase of carefully selected bonds will enable you to control the terms, or durations, of the bonds you buy.

Some investors want bonds to smooth out the volatility of their overall portfolio. And there’s no doubt bond funds will serve that function. But if you’re sure your five-year (or longer) cash needs are taken care of, volatility can be your friend in your longer-term stock or equity-fund portfolio. Its lets you buy low and sell high.

Since few bond funds have a record of consistently outperforming even the highest-quality bonds, we see little value in these funds. If you do want bond funds, be sure to choose no-load funds with low expense ratios such as Phillips, Hager & North Total Return Bond D (Fund code: PHN340 or RBF1340(NL0)). Its management expense ratio (MER) is 0.58 per cent.

And remember the average fixed-income fund carries an MER of 1.54 per cent, thus eating into your returns by that much.

This is an edited version of an article that was originally published for subscribers in the May 5, 2017, 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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