Bonds vs bond funds vs bond ETFs

Most bond funds are conservative, produce reliable returns and are unexciting. But most of them have trouble keeping up with the bond market. That’s why you’re better off buying a bond exchange traded fund. Or better yet, invest in bonds or GICs directly.

We seldom suggest bonds 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 maturity dates. And control of cash flow may be the most important reason for buying fixed-income securities.

The compound annual growth rates for the average Canadian fixed-income fund for the last one, three and five years are 3.0, 4.1 and 4.0 per cent, respectively. Over the same periods, the Barclays Global Aggregate Canadian Float Adjusted Bond Index, a benchmark for the Canadian bond market, returned 5.3, 5.6 and 5.2 per cent, respectively. And if you had invested in the exchange traded fund that tracks the Barclays index, Vanguard Canadian Aggregate Bond Index (TSX—VAB), your returns for the last one- and three-year periods, would have been 5.2 and 5.5 per cent, respectively. (Note that this fund was started in late 2011, so there is no five-year return.)

This past year, just 30 of 690 fixed-income funds managed to deliver a return that surpassed the 5.3-per-cent return of the Barclays index. And just 36 of these funds produced a return that exceeded the 5.2-per-cent return of Vanguard Canadian Aggregate Bond Index. That means if you had picked a random bond fund a year ago, you would have had a 5.2-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 — 1.71 per cent for the median fund in the category. Of course, the under-performance 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 (guaranteed investment certificate) 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

In recent years, investors have widely expected interest rates to rise. Problem is, rates have remained stubbornly low. If low rates are going to be around for awhile, 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, as some experts are forecasting, bond funds could do considerably worse, on average, than a bond purchased today. Keep in mind, the average Canadian fixed-income fund lost 2.6 per cent of its value 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.

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 quality.

Naturally, high-quality bonds will yield less than lower-quality ones. But even mid-quality companies provide substantial security for their corporate bonds. Today, for example, a government of Canada five-year bond yields about 0.54 per cent (assuming a purchase price of $5,000). A five-year bond from TD Bank yields about 1.49 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.

Buying bonds that mature, in say, 2036 makes little sense for most investors.

 

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