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Direct Investing in Bonds Can Help Investors Avoid ‘Yield Leak’

by Wayne Cheveldayoff, 2003-04-21

Investors in bond funds, or balanced funds with bond holdings, inevitably suffer “yield leak.” This occurs when a healthy chunk of interest earnings is eaten up by the annual fee paid to the fund manager. Except in some special circumstances where holding a bond fund makes sense, this is easily avoided through a strategy of direct investment in bonds.

The amount of yield leak depends on the fund. Bond funds have management expense ratios (MERs) ranging from 0.8 per cent to more than 2.25 per cent a year, with the average for Canadian bond funds in the order of 1.85 per cent.

Balanced funds, which normally consist of a bond component of around 30 to 40 per cent and the remainder in cash and equities, have MERs averaging around 2.5 per cent. This fee applies to the bond portion equally as it does to the equity and cash portions.

Most of the bond holdings are in government bonds (except in specialty high-yield funds where the focus is corporate bonds). With yields on government bonds ranging from 3 to 5.5 per cent, depending on the maturity, the MERs are devouring a large proportion of the interest being earned in the fund.

While fund returns (after fees) had been boosted somewhat by capital gains on bonds as interest rates fell in recent years, this is unlikely to be the case in the future as interest rates are already very low. Canada’s central bank governor David Dodge has warned of rising interest rates. In the United States, with government deficits escalating, any sizeable pickup in the economy will likely send bond yields higher (and bond prices lower).

While bond and balanced fund managers try to enhance their performance through trading in and out of different bond maturities, or switching back and forth between federal, provincial and corporate bonds, it would take a lot of this, and a lot of luck in making the right calls, for this type of trading to offset the sizeable bite from the annual fees, and few are able to do it.

Investors seeking to have bond holdings in order to achieve balanced portfolios can do at least as well as the managers, and usually better, by avoiding annual fees and investing in bonds directly. In the case of balanced fund holders, for example, splitting up the holding into a (pure) equity fund and bonds owned directly would eliminate the yield leak on the bond component of the balanced fund while still getting the benefits of a balanced portfolio.

In direct purchases of bonds, however, it is best to be mindful of the commissions charged by brokerage houses. They are normally within reason, but this is one area of the bond market that remains hidden from investors. Although regulators are contemplating opening it up with mandatory disclosure of the commissions charged on bonds, this hasn’t occurred yet. Dealers simply show the final price and yield without disclosing the amount of commission built in. You can ask your broker what the commission is, but there is no independent way of verifying the answer as you can with equity trades where the trade slips show the actual commission involved.

Another factor to consider is the difficulty of tracking the performance of bonds. There is no central exchange for bonds as there is for stocks, so pricing during the day, which is easy to see via Internet sites for stocks, is almost impossible to get for free for bonds without calling a broker or viewing a broker’s web site. For certain actively traded government and corporate bonds, some newspapers have daily or weekly listings. But for the most part, investors have to wait to receive their monthly statements in order to find out how their bond holdings are being priced.

There are two intra-day bond-pricing services available in Canada on the Internet for those willing to incur the charges. At www.ebond.ca, bond specialist Tim Fussner updates prices throughout the day on about 150 bonds ($12 monthly fee). At www.canpx.ca, which is a joint venture of several investment dealers, investors can get a similar service for a minimum $35 a month.

Investors contemplating the switch to holding bonds directly should first investigate the fees associated with selling a mutual fund position. For those in back-load funds, this fee can be as much as 6 per cent, depending on how long it has been held, and could reduce the expected benefits.

In a couple of special circumstances, it may make sense to stay with mutual funds. One would be where selling the mutual fund held outside of a registered account would trigger a significant capital gain and income tax bill.

Another would be where the intent is to hold high-yield corporate bonds. While investors can get great returns in this sector, proper diversification (namely holding in the order of 20 different bond issuers) is essential to minimize the risk of losing your capital from the default of one or two companies. Holding this many bonds is simply impractical for all but very large portfolios. For smaller portfolios, investing in a high-yield bond fund instead of the actual bonds is definitely wiser.

Nevertheless, for most investors in bond or balance funds, as long as they are willing to do some homework to understand bonds and investigate the alternatives, holding bonds directly is a winning strategy.

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©2003 Wayne Cheveldayoff