The trouble with bond funds

You would be hard pressed to find a qualified financial advisor who doesn’t agree bonds should play a significant role in any retirement investment portfolio.

Wall Street investors may shoot for big returns but when they’re your retirement dollars, preserving those returns over the long term is the priority – and that’s what bonds help do.

In a retirement portfolio stocks, or equities, are intended to grow the value of your nest egg. At the same time bonds should provide a safe and reliable stream of fixed-income to add to the value, and balance the risk that comes with stocks.

The proportion of stocks to bonds is determined by how much risk the individual investor wants to take, and when the investor will need to draw from the portfolio in retirement.

Broken income

Where financial advisors differ is in their definition of fixed income. Many feel mutual funds that hold bonds qualify as fixed income. In reality, bond fund returns are far from fixed.

The 50 or so bond funds available to most Canadians hold a variety of bonds with varying risk. It’s often hard to know which bonds and the degree of risk because mutual fund companies are not required to give a great deal of timely information.

Instead of holding bonds to maturity and collecting the yield, bond fund managers often speculate on the direction of interest rates and trade the bonds for capital gain. When interest rates are falling, the price of existing bonds goes up because they are paying superior yields. When rates are rising they fall in price because their yields are lower than new issues, and the investor could lose money.

With upward pressure on bond yields right now most bond funds are declining in value. As of July first, the majority have lost money over the past year and the average bond fund is down 2 per cent over the past six months.

In contrast a one year Government of Canada bond or Guaranteed Investment Certificate paid a yield of between one and 2.5 per cent over the past year.

Follow the money

So, why do financial advisors put fixed income investors at risk?

The fact is; many financial advisors are merely mutual fund vendors who work for mutual fund companies. Mutual fund companies generally don’t offer individual bonds. Instead, they wrap bonds into funds, call them fixed income, and charge fees to manage them.

Curiously, annual bond fees (known as the management expense ratio) can be as high as 2 per cent, which helps explain where the return from the bonds in the fund went.

Part of that annual fee goes toward compensating the financial advisor (mutual fund vendor), which calls into question whether the fund is being sold because it is a good fund or because it pays the highest commission.

Many bond funds also impose an additional fee when it is bought or sold - called a load - to further compensate the vendor.

The real thing

Full service financial advisors can provide bonds that are guaranteed to generate returns at a fraction of the cost.

In many cases the client pays a flat fee for the advisor to manage the entire portfolio – stocks and bonds. Unlike bond funds, the fee is not based on a percentage of the total investment so it remains pretty well the same as your nest-egg grows.

Advisors can also earn commissions on each purchase but fees are low because the bonds are held to maturity and not traded.

A qualified advisor can boost returns from a bond portfolio by staggering or “laddering” the maturities over time to take advantage of rising yields as often as possible.

A laddering strategy also permits longer term, higher paying, bonds without sacrificing liquidity.

Finally, a real advisor can tailor a bond portfolio to an individual’s risk level by diversifying the type of bonds to include higher risk, higher paying bonds.

The important thing is: returns are something you can count on.