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Invest Style

Is the yield part of your portfolio working?

Here's a guide to tuning it up

Is the yield part of your portfolio working?


Globe Investor Magazine Online, April 17, 2009

Is your fixed income broken? Did it properly protect you during the market meltdown?

The worst performing Canadian fixed-income, or bond funds, lost as much as 6.5 per cent of their value over the past year - a sad state of affairs when you consider they are mostly loaded with top-rated Canadian government bonds that always pay a yield at maturity.

Fixed income is an asset class that is meant to preserve wealth, to anchor or stabilize a portfolio. As we age, the proportion of fixed income in our portfolios should increase so there's plenty of liquid cash when it's time to withdraw money. If a portfolio is too heavily weighted in stocks the investor risks having to sell in a down market . such as last year.

Fixed income is also intended to yield steady returns through thick and thin, but historically low interest rates these days have meant historically low yields. The average Canadian fixed-income fund returned a paltry 1.6 per cent over the past year.

For some investment advisers the problem isn't fixed income - the problem is fixed-income funds. "Fixed income means you get your principal back at the end of a fixed period," say Jaime Carrasco from Blackmont Capital. "You are assuming that no matter what, at the end of that period you are going to get your money back from whoever you lent it to. Bond funds have a risk of loss."

To understand the difference between bonds and bond funds it's important to understand how bonds are priced. Basically, a bond pays a fixed amount of interest over a fixed period of time when it matures. However, over the course of that term to maturity, rising interest rates will devalue that bond because other bonds being issued with the same term to maturity will pay higher yields. Inversely, falling rates will increase the present value of existing bonds.

When bond fund holders look at their statements it is merely a snapshot of the value of the bonds in the fund at that point in time. The bonds inside will still yield the stated return at maturity, but the unfortunate investor who needs the funds at that time will take a loss. A bond fund could also suffer losses if several unitholders decide to cash out and the manager needs to sell bond holdings before maturity.

"You are subject to the whims of the mutual investors," says Mr. Carrasco.

Like many financial advisers, Mr. Carrasco puts his client's fixed-income dollars in bonds - just bonds. The former bond trader initiates a popular strategy designed to maximize returns and minimize risk called laddering. Risk levels are diversified to match an individual client's return goals and terms to maturity are staggered to coincide with the client's income needs. He says a conservative laddering strategy with Canadian government bonds and bank GICs can currently return up to 4.5 per cent annually. "If you own a bond ladder for five years you know what your cash flow is coming in - that's fixed income," he says.

"It's an extraordinary situation," says Paul Gardner, a partner at Toronto-based Avenue Investment Management and a former bond fund manager. He says the past year has been far from typical and over the long term most bond funds post positive returns. Despite dismal performances over the past few years, the average Canadian fixed income fund has generated an annual average return of 7.2 per cent over the past 20 years.

In terms of risk, Mr. Gardner argues a bond fund is better than a bond portfolio if an investor needs cash before the next maturity date. "A bond fund is more liquid because you have the benefit of diversification," he says.

Mr. Gardner takes the definition of fixed-income one step further to include high-yield bond funds, which produce higher returns but carry more default risk. "If you're willing to completely give up any yield, government bonds are solely there for capital preservation," he says.

So what exactly is fixed income? Mutual fund research sites like GlobeFund classify Canadian, global and high-yield bond funds as fixed income. Some money managers include the fixed-income portion of balanced funds, and at one time income trusts were considered fixed income (that was until income trusts plunged in value in 2007 when Ottawa announced an end to their special tax status by 2011).

Morningstar also classifies bond funds as fixed income in its data base but Morningstar Canada senior fund analyst Philip Lee admits it's a point of debate. "If the bond manager held every single bond from the time of purchase to maturity, there's a good likelihood that you'll get the coupon payments and you'll get the money at maturity," he says. "But it's the uncertainty in between that causes the price of the bonds to fluctuate."

According to Morningstar Canada, the biggest difference between bonds and bond funds are the fees. The average management expense ratio (MER) for fixed-income funds is 1.47 per cent - charged each year after purchase. In comparison, fees could vary for bond portfolios but Mr. Carrasco and other portfolio managers impose a one-time charge of 0.25 per cent for each bond purchased.

To put fixed-income fund fees into perspective, a 1.5-per-cent MER on a fund with a three-per-cent return is a 33-per-cent cut of the profit - for a fund that requires the manager to merely buy and hold securities.

"The fees for bond funds are the biggest detractors of performance - no doubt," says Mr. Lee.

Dale Jackson is a producer at BNN

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