Buy bonds directly or in an ETF

Most bond funds are conservative, produce reliable returns, are unexciting and have trouble keeping up with the bond market. You’re better off buying a bond ETF or investing directly.

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Most investors will be better off buying bonds directly or in an ETF. Managed fund fees and expenses will eat up most of a bond fund’s income.

We seldom suggest bond funds for any investor. That’s because these funds have considerable difficulty beating the bond market by enough to offset their management expenses. What’s more, when you invest in bond funds, you give up control of your maturities. And control of cash flow may be the most important reason for investing in fixed-income securities.

The compound annual growth rates for the average Canadian fixed-income fund for the last one, three and five years are 5.2, 4.8 and 3.2 per cent, respectively. Over the same periods, the Bloomberg Barclays Global Aggregate Canadian Float Adjusted Bond Index, a benchmark for the Canadian bond market, returned 9.1, 6.4 and 4.1 per cent, respectively. And if you had invested in the exchange-traded fund that tracks the Barclays index, Vanguard Canadian Aggregate Bond Index ETF (TSX—VAB), your returns for the last one-, three- and five-year periods would have been 9.2, 6.3 and 4.0 per cent, respectively.

Management expenses reduce your returns

This past year, just 5.3 per cent of 2,504 fixed-income funds managed to deliver a return that surpassed the 9.2 per cent of the Vanguard Canadian Aggregate Bond Index. And just 5.6 per cent of these funds produced a return that exceeded the 9.1 per cent return of the Barclays index. That means if you had picked a random bond fund a year ago, you would have had just a five-per-cent chance of doing better than the Vanguard ETF.

The main reason for the relatively dismal performance of fixed-income funds, of course, is the management expenses incurred by them. Many of them typically have a management expense ratio that exceeds 1.00 per cent. Of course, the underperformance of these funds may be worth it for the lack of effort required.

But perhaps the most important requirement when you invest for income is your ability to match an investment’s cash flow to your needs. Rather than buy a bond fund, you could buy a bond or GIC that matures in, say, four years, or six, if that’s what you need. You simply can’t do that with a bond fund.

Control your own affairs

Over the past decade, investors have widely expected interest rates to rise. But not only have they remained low, they’ve plunged even lower with COVID-19. If rates are to stay around their current low level for a while, bond funds will be hard pressed to turn out decent returns. Of course, if rates fall further than they already have, then returns could look somewhat better.

But if rates should rise even a little over the next year, which would be possible if the global economy rebounded strongly, bond funds could do considerably worse. Keep in mind, the average Canadian fixed-income fund lost 0.3 per cent in 2013, 2.6 per cent in 1999 and 5.1 per cent in 1995.

Unlike stocks, bonds or GICs are relatively easy to pick and buy. Most government of Canada bonds have the same credit quality. So all you need do is choose a maturity date that most closely meets your future cash needs. You can be certain the money will be there (or at least the par value), with interest. But GICs are perhaps more compelling investments given their higher yields.

How to buy bonds

To buy bonds directly, you’ll need a broker. If you deal with a full-service broker, discuss with him or her what you’re looking for. A discount broker will list the bond issues it has available on its website.

Choose an approximate maturity date, and know the amount of money you want to invest. Your broker can provide you with a list of the securities it has available. They may be federal, provincial or even municipal bonds. Plus, most brokerages carry corporate bonds of varying qualities.

Naturally, high-quality bonds will yield less than lower-quality ones. But even mid-quality corporations provide substantial security for their bonds. Today, for example, a government of Canada five-year bond yields about 0.20 per cent (assuming a purchase price of, say, $5,000). A five-year bond from Royal Bank yields about 0.82 per cent.

We typically recommend fixed-income securities with no more than five years to maturity. As they mature, if you don’t need the money, reinvest for another five years. Even that can add an element of risk.

Buying bonds that mature, in say, 2040 makes little sense for most investors.

This is an edited version of an article that was originally published for subscribers in the August 28, 2020, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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