Bond funds seem like the answer to a number of investor needs. They provide income, apparent safety in your portfolio and even speculation on interest rates. But they fail to provide for the most important need of the income-seeking investor—control.
When it comes time to draw income from your investments, bond funds fail to make the grade. They can’t provide the orderly flow of income you need to make sense of your affairs.
What’s more, in the case of bond funds, the normal benefits of mutual funds—professional management and diversification—don’t justify the cost from sales loads and management expenses that you incur with many of these funds.
First, performance. Bond funds don’t offer guaranteed returns year after year. Did you know, for example, the average Canadian fixed-income fund lost 5.1 per cent of its value in 1994, and 2.6 per cent in 1999?
And in 2018? The median fund in the category declined 0.3 per cent. If you were unlucky enough to hold the worst-performing fund in the category, the value of your fixed-income investments would have declined 8.7 per cent.
What do these figures mean if you’re investing for a cash flow of interest from bonds?
In the strictest sense, the answer is, very little. The only difference between a bond fund and a portfolio of bonds is that the value of your fund will be published every day. But you may not bother to check the value of a portfolio of bonds if you’re investing for the interest they generate.
Managers often trade bonds
Your fund manager, however, may see things differently. Motivated by monthly performance, your bond-fund portfolio manager will almost automatically invest in bonds he feels will gain the most (or lose the least) value over and above the interest they generate. That means he or she will constantly adjust the duration of the bonds in the fund’s portfolio in an attempt to profit from changes in interest rates. Any success in trading bonds will, incidentally, incur income-tax liability for investors, even though it may provide no increase in cash flow.
And if your bond-fund manager holds a lot of long-term bonds, you will have effectively locked in long-term, fixed returns. If interest rates rise—a phenomenon that usually accompanies inflation—you may face declining purchasing power even if your dollar income remains unchanged.
If your manager is right, then, you’ll gain. If he is wrong, you’ll be the loser. But when it comes to your income, we think that’s a risk you ought not take.
That’s why we recommend holding on to control of your income-producing securities by investing in bonds, strips, mortgages and GICs directly and controlling the terms of these investments according to your needs.
Build a bond ladder
We generally recommend buying fixed-income securities with no more than five years to maturity in a rising interest-rate environment, such as we find ourselves in now. What’s more, we don’t recommend putting all your money in five-year securities.
Rather, our general rule of thumb is to put one fifth of your fixed-income portfolio into each of one-year through five-year maturities. As each matures, reinvest the proceeds for five years. You’ll usually get a higher rate in five-year than shorter maturities. And you’ll always have some liquidity within a year. Plus, you’ll usually find longer (i.e. more than five years to maturity) bonds yield only a small amount more.
In periods of rising rates, such as now, you might want to shorten your ladder to three or four years. That way, more of your money matures sooner, letting you reinvest it at higher yields.
In periods of falling rates, you might want to lengthen your ladder beyond the five years we recommend, increasing your yield and taking advantage of the capital appreciation potential that bonds offer in these environments.
This is an edited version of an article that was originally published for subscribers in the January 25, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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