Income funds need a different perspective

Investing for current income requires an entirely different way of thinking than does investing for growth. But mutual funds that offer current income as their main purpose still report their performance the way equity funds do.

The most important starting point for any investment program is a clear understanding of your objectives. Some of the main investment objectives are safety of principal, liquidity, income and long-term growth of capital. Once you’ve decided on your objectives, it’s much easier to pick securities that have the best chance of fulfilling those objectives.

If your objectives include safety and a steady, predictable return, fixed-income securities are the ones to choose. These include GICs, bonds, mortgages and mutual funds that invest in them.

Problems can, however, arise for investors in income mutual funds because of the way these funds report their results. For example, bond funds can actually lose money from time to time, though on a calendar-year basis this hasn’t occurred for quite some time. The average Canadian bond fund lost over five per cent in 1994. Even the average mortgage fund and dividend fund lost money in that year. And again in 1999, the average bond fund lost 2.5 per cent.

But many investors may not realize that if they use the same logic, they lost money on GICs in these years too. That’s because if they could have sold these securities, no buyers would have bought them without a discount.

Bonds win and lose at the same time

Bonds, dividend-paying stocks and mortgages are all marketable securities. When interest rates rise, they become less valuable, since they pay a fixed return based on older, lower rates. When mutual funds calculate their return, they take that decreased value into account, along with interest and dividends received by the fund. Since interest rates rose steadily through most of 1994, the value of bonds and other fixed-income securities fell, even while these securities still paid interest.

When you buy a GIC, however, you tend to ignore the fact that if you could sell your security, it would fetch less than your original principal. Nobody confronts you with a new, lower value of your investment. Of course, if you’re invested for five years at 2.5 per cent, you may feel that you’ve lost out on the subsequent higher rates, but at least you’re still collecting that 2.5 per cent, and you know you’ll receive your full principal back at maturity. Given these circumstances, you may not feel as though you’re actually losing.

Most investors buy fixed-income securities for safety, dependability and income. Once you make your investment, you know exactly what to expect. But the changes in value of bonds, dividend-paying shares and mutual-fund shares point out another reason some investors buy fixed-income securities. The sometimes rapid changes in prices suggest that profits can be made by speculating on changes in interest rates. That’s true. And you can suffer losses as well.

We’ve always felt few can boast consistent success speculating on interest-rate swings. But that’s what many bond-fund managers try to do. You, the investor, have no control over how they go at it with your money. You may prefer to keep your investments to at most five-year terms. But your fund manager may prefer to load up on 20-year bonds. Long-term bond prices move more violently when interest rates change than do short-term bond prices. That means your manager is taking greater risk with your money than you may want.

Bond prices are high

Some pundits suggest that interest rates will stay low for quite some time to come. That may be true. But we wouldn’t bet on it.

That’s not to say we doubt this prediction. It’s just to say we wouldn’t get heavily exposed to fixed-income securities when interest rates are low — meaning prices are high. Sure they may stay high. But the potential downside for longer-term bonds is substantial.

This provides a strong reason to stick with GICs and direct investment in bonds for your fixed-income portfolio. You won’t be paying a management fee to someone to use your money to pursue objectives unsuitable for you.

 

Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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