After posting modest returns in 2014, Canadian bonds have gotten off to a strong start so far this year. Year to date, the FTSE Universe Bond Index has gained 4.2 per cent. That leaves many holders of bond funds wondering what to do now.
Perhaps the most basic decision each individual investor must make concerns his or her tolerance for risk. Risk tolerance depends on personality and temperament, as well as on personal financial circumstances and need.
If you simply can’t stand to see the value of your investments go up and down, you should keep the equity portion of your portfolio relatively small. Then too, if a sudden, even temporary drop in the value of your portfolio could cause personal hardship, you can’t tolerate a large holding of equities.
The point is, use equities for growth and protection against inflation, and fixed-income securities for safety and liquidity. But above all, make the decision of portfolio balance before you begin to invest.
Control adds value
Since fixed-income investments address shorter-term needs such as liquidity, we think it’s appropriate for individual investors to retain as much control over their fixed-income portfolio as possible. Fortunately, the market for these securities is extremely large. It includes bonds, GICs, stripped coupons, mortgages and others.
The shear size of the fixed-income markets makes it difficult for even the largest bond fund portfolios to realize significant economies of scale. That’s why we think you’ll do better to invest in fixed-income securities directly, rather than through funds. After all, the median Canadian fixed-income fund incurs a management expense ratio of 1.80 per cent. We doubt that many funds can consistently ‘beat the market’ by even this much.
The result is that fixed-income fund managers try to justify their existence through trading activities. They try to outsmart the market by speculating on interest rates — an activity that may not be right for you.
Trading in bonds can result in an extremely volatile fund. That, in turn, can leave you without the very characteristics you want from your fixed-income portfolio — predictability. That’s the other reason we recommend you invest in fixed-income securities directly. You can choose terms to maturity, quality and payout schedules to fit your own needs.
Many bond funds that experienced modest gains in 2014 are now showing healthy short-term gains. Consequently, their unit holders risk becoming complacent. Mind you, interest rates may experience little upward pressure in the near future. And if rates fall further, bond funds will continue to make gains. But sooner or later, rates will move up, and bonds will incur capital losses.
Unfortunately, this all falls into the realm of speculation on interest rates — an exercise few investors, if any, have consistent success at.
If you hold bond funds, we suggest you assess your position according to your investment needs. If you require liquidity or predictability, redeem them and invest directly in securities that meet your individual needs.
Use GICs for income
For income, we recommend a balanced portfolio of GICs equally allocated from one to five years to maturity. This strategy avoids undue speculation on interest rates. Each year, you’ll reinvest 20 per cent of your portfolio in a new five-year security. More often than not, you’ll get a higher rate on the five-year GIC than you would on a shorter-term investment. But you’ll still have 20 per cent of your portfolio coming due within one year, to take advantage of higher rates should they occur.
If, on the other hand, you have a relatively long-term outlook but hold bond funds for the sheer safety, you might want to continue to hold. That’s especially true if you face a sizable redemption fee to redeem. But when your redemption fee approaches zero we think you can achieve comparable investment results by doing your fixed-income investing directly. Plus, you’ll avoid having someone else speculate on interest rates with your money, and your portfolio can meet your personal needs.
Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846