Your guide to picking a bond fund

By Andrew Allentuck
Globe Investor Magazine Online, January 24, 2008

Bond markets usually soar when equity markets swoon and - given the troubles that U.S. and Canadian stocks have had in the last half year- the time for bonds has arrived.

The proof is in the numbers. In the six months ended Dec. 31, the S&P/TSX composite lost 0.5 per cent. In the same period, the DEX Universe Bond Total Return Index, formerly called the SC Universe, gained 4.5 per cent. If there is more mayhem to come in stocks, then bonds are likely to be life preservers for portfolios.

Interest rates are likely to fall and existing bonds with fixed coupons will look attractive, rising in price as new bonds with lower coupon payments hit the market. Bond funds can capture these gains efficiently, for they buy and sell bonds with much lower trading costs than individual investors have to pay. Funds have professional management or design, and they offer diversification.

But which kinds funds to buy? The choices range from:

- Canadian government bond funds that are moved by interest rate changes

- Investment grade bond funds composed of government issues and corporates that boost potential returns and risk

- High yield bond funds that add still more risk and potential return

- Global bond funds that trade on interest rate cycles in various countries

- Funds of real return bonds that gain value as inflation rises and lose value as it falls

In all bond funds, which have low returns to start with, fees are the crucial factor, says Dan Hallett, president of mutual fund research company Dan Hallett & Associates in Windsor, Ont. "Bond managers can actually detract from value, but if their fees are low enough, they can look great."

Go with Canadian issues, advises Ed Jong, senior vice-president for fixed income at Mak Allen & Day Capital Partners Inc. in Toronto. "I would put my money into a domestic government bond fund," he said.

One low-fee bond fund is the Phillips Hager & North Bond Fund with a 4.29-per-cent average annual compound return for the three years ended Dec. 31, and a 0.59-per-cent management expense ratio, a fraction of the 1.9-per-cent median MER on Canadian bond funds. Another is the RBC Canadian Bond Index Fund with a 4-per-cent return and a 0.7-per-cent MER in the same period. Both beat the 3.1-per-cent average return of Canadian fixed income funds for those three years.

When investment grade corporate bonds are mixed in with government bonds, there is more risk, but also more potential return. "Investors concerned with credit risk should pick bond funds with about three quarters of their money in government issues with the balance in high quality corporates," said Michael McHugh, who manages fixed income portfolios for Dynamic Mutual Funds Ltd. in Toronto. His own fund, the $281.5-million Dynamic Canadian Bond Fund, holds 27 per cent in corporate issues.

Junk bonds, which tend to march alongside the stocks of their issuers, have much more risk than investment grade issues. Junk bonds can have big returns, but only at the right point of market cycles. Currently, it's too early to start buying high yields," says Barry Allan, President of Marrett Asset Management Inc., a leading high-yield specialty bond management company in Toronto. "The problems facing markets have more to do with credit issues than they do with fundamental economics and equity valuations." His advice - for portfolio protection, stick with government issues that have no credit risk at all.

Global bonds are a hedge on the Canadian economy. "If demand for Canadian commodities declines, then the loonie will tend to fall," says Randy LeClair, senior vice-president and bond portfolio manager for AIC Investment Services Inc. in Burlington, Ont. "That would cause assets priced in other currencies to appreciate. Moreover, though North American interest rates are declining, central banks in Europe and in Australia and New Zealand are still raising rates, pushing up their currencies. So global bonds make sense in a defensive portfolio." Among top performers in the field - the RBC Global Bond Fund gained 3.2 per cent in the 12 months ended Dec. 31, compared with the 5.9-per-cent average loss of global fixed income funds in the period.

Canadian real return bond funds are a small field with only 10 players. Real return bonds rise along with increases in the consumer price index. But RRBs present a problem of timing.

"In an environment in which inflation is declining, the short-term outlook for RRBs is not very good," Mr. Jong says. "RRBs and funds of RRBs will tend to lag conventional bonds for the next few years."

Nevertheless, RRBs do add a layer of protection to conventional government bonds. With a $500 minimum investment, one can buy into the Dynamic Real Return Bond Fund with a 3.4-per-cent average annual compound return for the three years ended Dec. 31. The biggest player is the $1.34-billion TD Real Return Bond Fund with a 2.62-per-cent average annual compound return in the same period and a $100 minimum investment. Established in 1994, the TD fund has produced five years of double digit returns since 2000, notes James Gauthier, investment funds analyst at Dundee Wealth Management in Toronto.

Bottom line: Bond funds are a tradeoff. You get diversification and professional management or at least professional design in the case of bond index funds. But there is a downside, says Caroline Nalbantoglu, a registered financial planner with PWL Advisors Inc. in Montreal. "Bond funds can reduce portfolio volatility, but they can also lose money. If you want the absolute guarantee of no loss, buy actual government bonds. You get a guarantee of payment that no bond fund can provide and you get real cash when the bond is due."