Four key questions to ask when investing in bonds

You've used asset-allocation calculators and compared your portfolio to target-date funds geared toward your retirement date. You may have even checked in with a financial advisor for a temperature check. And all systems point in the same direction: It's time to add some bonds. Check that--it's way past time to add some bonds.

But if you're like many investors--even seasoned ones who have long been navigating the stock market--you may be balking. Even if you're willing to swallow your misgivings about bonds' meagre yields and the risk that rising rates could crunch bond prices, you may be dogged by a more basic issue: where to start?

If you find yourself in this situation, it's helpful to consider your major choices one by one. By the time you're through, you'll be well on your way to assembling a bond portfolio that makes sense for you given how much time you want to devote to your portfolio, your opinions on active versus passive management, your desire for diversification, and so on.

Choice 1: Will you buy individual bonds or bond mutual funds?

The first decision bond investors must make is the delivery system: individual bonds or a bond fund? For most investors, especially those starting out, the simplicity, diversification and professional management that come along with investing in a bond fund can be difficult to beat. But individual bonds may be appropriate in some instances. Here are the pros and cons of each strategy; this article does a deeper dive into the question of whether to invest in individual bonds or use a fund.

Individual bonds

Why: The key benefit of buying individual bonds is that you can readily match the bond's maturity to your time horizon. Assuming you've bought a bond from a high-quality issuer, you'll receive your coupon payments and get your principal back when the bond matures, even though interest rates may have moved up, down and sideways over your holding period. And by buying individual bonds, you can, in theory, cherry-pick the bonds that offer the best combination of safety and yield. You can also circumvent fund-management fees, but you'll face other costs as an individual-bond buyer. So, those cost savings could be illusory.

Why not: While the marketplace for individual-bond buyers has improved over the past decade, it can still be tricky to research individual bonds' fundamentals and determine whether the price you're paying is a fair one. This is especially true once you venture beyond government-issued and high-quality corporate bonds. Trading costs can also eat into the returns that small investors earn on individual bonds. It can also be difficult, as a smaller investor, to build a portfolio of individual bonds that's adequately diversified; one bum holding can disproportionately affect your results. Moreover, the assumption that individual bonds protect you from rising rates is not exactly true. If rates go up, your choices are to stick with your lower-yielding bond--and face an opportunity cost--or to sell your bond at a discount to swap into a higher-yielding investment.

If you go this route for all or part of your bond exposure: Focus on very high-quality, highly liquid bonds and make sure you fully understand all of the costs and risks that come along with making the investment.

Bond mutual funds

Why: Fund investors--even small ones--get diversification and professional management in a single shot by investing in a bond fund. And while a bond fund may incur short-term losses when interest rates rise, the bond-fund manager will then be able to swap into new, higher-yielding bonds as they become available, thereby offsetting the hit to principal. Large institutional investors, like mutual funds, will also be able to obtain lower trading costs than small investors; in a low-returning asset class like bonds, that can be a major advantage.

Why not: The fees you pay for fund management may cut into your return. And there's no guarantee you'll be able to take exactly as much out of your bond fund as you put in. If interest rates rise over your holding period or if the types of bonds in the portfolio slump for some other reason, you could have a loss in your holdings.

If you go this route for all or part of your bond exposure: Be sure to start building your bond-fund portfolio with core, intermediate-term funds that give you a lot of diversification in a single holding. Be careful with funds that focus on a narrow part of the market or have high fees, as high fees correlate neatly with risk-taking.

Choice 2: Index funds versus actively managed funds?

If you've decided to focus on funds, your next question is the same one that confronts equity-fund investors: index or active? Here are the positives and negatives of both approaches.

Index funds

Why: The key advantage to indexing is the ability to obtain exposure to an asset class at a very low cost. Ultralow expenses are a particularly big advantage for bond funds, because the range of returns in high-quality bond categories is very narrow. The FTSE TMX Canada Bond Index, which many Canadian index bond funds track, tilts heavily toward the highest-quality bonds; thus, the index has historically held up well in periods of equity-market weakness. Its long-term returns beat all but a handful of funds in the Canadian Fixed Income category, while its volatility has been middle of the pack.

Why not: Index funds don't have the same flexibility that many active fund managers do--they can't retreat to cash in periods of rising rates, for example. Moreover, because yields on high-quality bonds have been at historical lows for several years, their fees take a much bigger bite out of their returns than they did when rates were higher. The average Canadian Fixed Income fund has a management-expense ratio of 1.14%, which is a significant hurdle when intermediate-term bonds pay around 2.8%.

If you go this route for all or part of your bond exposure: Search for the cheapest fund you can find, because bond index funds are a commodity. Also, make sure you understand the index's construction and, if you're searching for all-inclusive bond exposure, be sure to augment your core bond index fund with the security types it's missing.

Active funds

Why: The main attraction behind active funds is the ability to outperform a market benchmark. Of late, investors have flocked to active bond funds because of their perceived ability to avoid big losses in interest-rate increases; whether that will play out in practice has yet to be determined. Some of the best active bond funds keep their fees very low, giving their managers a fighting shot at beating the benchmark without taking on excessive risks.

Why not: Active funds are generally more expensive than their indexed counterparts, and that can weigh on both absolute and relative returns. Moreover, some active funds operate with tightly constrained mandates, so in practice they may not be able to deliver the level of outperformance that investors are expecting. Alternatively, an active manager could position the fund one way and the market could go the other; manager bets aren't always vindicated.

If you go this route for all or part of your bond exposure: Seek out a proven manager with deep analytical resources. Don't expect all-weather performance, either: High-quality-focused funds tend to behave better in periods of economic and equity-market uncertainty, while lower-quality funds tend to thrive when the economy and stocks are also going strong. Make sure you understand which type you have. This article gives a list of some of Morningstar's favourite bond funds.

Choice 3: Diversify internationally?

If you've determined what the core of your bond portfolio will look like, you can stop right here. But many investors have embraced international bonds as a means of further diversifying their bond portfolios. Here are the key pros and cons of doing so, as well as details for some of the variations of international bond-fund types.

Why diversify internationally: Diversification is the main benefit of owning foreign bonds. Even if you buy a fund that hedges its currency exposure--that is, uses futures contracts to negate the impact that foreign-currency swings can have on returns--you can still pick up exposure to countries' varying interest-rate climates, and that can help improve the risk/reward profile of your bond portfolio. Also, since the corporate and high-yield bond markets are much more developed in the United States than they are in Canada, it's almost essential to look south for exposure to those types of bonds.

Why not diversify internationally: Unhedged international-bond funds are good diversifiers for Canada-focused bond portfolios, but the high volatility that accompanies foreign-currency swings makes them inappropriate for investors with short or intermediate time horizons. Hedged foreign-bond funds are much less volatile, but it's debatable whether their modest diversification benefit offsets their management fees and hedging costs. Generally speaking, foreign-bond exposure will cost you more than a Canada-focused bond fund or ETF.

If you go this route for all or part of your bond exposure: Make sure that you fully understand the fund's strategy. In addition to the hedged versus unhedged distinction, international-bond funds vary in whether they invest in U.S. bonds as well as overseas, whether they buy government or nongovernment bonds, and how much, if anything, they invest in emerging markets. Also, understand how the international-bond fund fits in your portfolio; you may already have some international-bond exposure via your intermediate-term, multisector or nontraditional bond fund.

Choice 4: Tilt your portfolio's exposures?

As with equity portfolios that emphasize stock types like dividend payers, small caps or value stocks, bond portfolios may also tilt toward certain parts of the bond market--either on a short-term tactical or long-term strategic basis. The goal may be return enhancement, risk reduction or both. Here are the pros and cons of incorporating tilts into your portfolio.

Why tilt: Investors may incorporate tactical tilts in an effort to capitalize on short-term market dislocations or to avoid trouble spots--for example, many investors have been tilting their portfolios toward cash and short-term bonds in recent years in an effort to shield their portfolios from losses in case interest rates rise. Alternatively, investors may maintain long-term strategic tilts to enhance their portfolios' long-term risk/reward profiles. For example, high-quality corporate bonds have historically delivered higher returns than government bonds without substantially higher volatility.

Why not tilt: The big risk with tilts--either opportunistic, tactical ones or those that are long term--is that your portfolio will be leaning in one direction and the market will go the other. The many fund managers and individual investors who have maintained short-duration portfolios because they expected interest rates to rise, for example, have faced an opportunity cost as interest rates have stayed low and even declined.

If you go this route for all or part of your bond exposure: There are a few ways to implement tilts in your fixed-income portfolio. You can implement tilts yourself, emphasizing, for example, short-duration or more credit-sensitive bond types. Alternatively, you can outsource that decision-making to a professional fund manager to implement the tilt for you. PH&N Total Return Bond , for example, has historically maintained an emphasis on corporate bonds at the expense of government bonds.