Buy bonds directly; say no to bond funds

Bonds account for much of Canadians’ investments. And bond funds make up a large part of Canada’s mutual fund business. But investing in bond funds can deny you the very thing bonds provide best — control.

We recommend you buy your fixed-income securities directly rather than through funds. That’s because we see bonds — fixed-income securities as they’re called — as a tool for planning and delivering on your cash-flow needs. Ultimately, cash flow is the sine qua non of successful investing. As a diversifying tool, you don’t need bond funds in a carefully constructed portfolio.

Most investment advisers, we included, suggest equities only if you have plenty of time to hold. Some suggest five years, others much longer. But what should you do if you need cash back from your investments sooner than five years? Put another way, what should you do to your portfolio as you approach an investment goal and need cash within five years?

That’s where fixed-income securities come in. You can buy bonds or other securities that pay interest in timely fashion and mature on a known date. Use them as a source of cash when you need it. And if you stick with government bonds, you needn’t worry about default.

Bond funds don’t mature

The problem with bond funds, then, becomes clear. They don’t mature. And they can lose money over painfully long periods of time. In 1996, for example, the average Canadian bond fund lost 6.4 per cent. That’s just not a reliable and timely source of cash.

We also recommend holding fixed-income securities with no more than five years to maturity. The risk of rates rising from their current, historically low levels simply outweighs the benefit of increased yields available from longer-term bonds.

Right now, for example, the yield on a 10-year Government of Canada bond exceeds that of a five-year bond by less than half a percentage point. And the 30-year bond’s yield exceeds the five-year bonds by just under a percentage point. That’s not much of a reward for tying up your money for so long.

While many bond funds hold considerable portions of their portfolios in longer-term bonds, you can buy funds restricted to shorter-term bonds. But the median fund’s fee of 1.50 per cent in this category makes them unattractive. Indeed, the median fund returned a gain of just 1.7 per cent over the last 12 months.

If you shop around, you can find GICs that offer higher returns than bonds. And you won’t have to pay commissions when you buy them. But individual bonds work well, too. Many discount brokers offer them in terms you need.

How to build a bond portfolio

To optimize your holdings of fixed-income securities for more than five years, place one fifth of this part of your portfolio in each of one- through five-year securities. Then, every year, renew the maturing securities for five years. That way, you’ll always get the five-year rate on new investments. And you’ll always have securities maturing within one year.

This approach to portfolio building — equities for the long term, bonds or GICs for the short — is all about control over your assets. And in the case of bonds, where you need maximum control, you simply have little or no control when you buy bond funds.

Another reason to say no to bond funds

Bonds make good instruments with which to speculate on interest rates. If rates fall, bond prices rise; and, of course, vice versa.

The longer a bond’s term and the lower its coupon, the greater will be the action as rates change. Plus, you can get huge margin loans against bond holdings.

So if speculation is your bent, bonds chosen specifically for the purpose will serve you best. Even in speculation, bond funds make a sluggish tool.


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

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