Bond funds lack flexibility

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

We recommend bonds and GICs as suitable for any money you’ll want back in five years of less. But why not bond funds? And should you hold bonds or bond funds in your longer-term portfolio?

Over the past year, the median Canadian fixed-income fund has gained an impressive 5.9 per cent. Over the past five years, however, the compound annual gain is less impressive, at about 2.5 per cent.

Future returns will depend on the direction and magnitude of changes in interest rates. With concerns about slowing economic growth, investors have taken refuge in government bonds, bidding up their prices and thereby pushing their yields down. This trend may have further to run in the short term. If the trend reverses itself, bonds could conceivably produce negative total returns.

Bond funds sometimes lose money

With fluctuations in interest rates, you 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 2013, for example, the average Canadian fixed-income fund lost 1.1 per cent. In 1994, the average bond fund lost 5.1 per cent. If you needed to redeem a bond-fund investment in either of those years, you likely redeemed at a bad time.

So we repeat our advice. For at least five years’ income, buy 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 some bond action.

For maximum trading action seek high duration

If you’re convinced rates will fall further, 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 these two—duration. For maximum action, you’ll want bonds with the highest duration. If you’re into trading in bonds, your broker may be of some help in getting this figure.

But again, you have no control over these characteristics when you invest in a bond fund. Only a direct purchase of carefully selected bonds will let you control the durations of the bonds you buy.

Some investors want bonds to smooth out the volatility of their overall portfolio. And 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 portfolio.

This is an edited version of an article that was originally published for subscribers in the August 2, 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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