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Bond mutual funds too costly for RRSPs

by Wayne Cheveldayoff, 2004-01-16

Of the many ways of investing in bonds in an RRSP, mutual funds are the least attractive. This is because mutual funds charge hefty fees that eat up a large portion of the potential return.

Interest rates on high-quality bonds currently range from 3 to 6 per cent, depending on the term to maturity. At the same time, bond funds have annual management expense ratios (MERs) ranging from 0.85 to 2.25 per cent, averaging around 1.85 per cent. Thus, the fees put a major dent into what bond investors could otherwise expect to receive.

Many investors havenít noticed the impact of these fees. This is partly because the returns on bond funds (after fees are deducted) have been decent in recent years, averaging in the 6-per-cent area. The published returns have been boosted by the ongoing decline of interest rates, which has increased the prices for longer-term bonds held in the portfolios.

But this is about to change. Interest rates are unlikely to go much lower and, in fact, many economists expect them to rise substantially in the coming two years as the economy grows rapidly. In an environment of rising interest rates, longer-term bond prices will decline and bond funds will perform poorly Ė essentially the opposite of what weíve had for several years.

Mutual fund fees are similarly an unnecessary burden for holders of balanced funds, which have MERs in the 2.5-per-cent range. This fee applies equally to the bond portion (making up about 30 or 40 per cent) as it does to the equity portion of a balanced fund.

Itís understandable that an investor may want to pay a mutual fund fee of this kind to have equities professionally managed. But for bonds, itís too much, and itís unnecessary.

Bonds are easy to understand. They are ideal for do-it-yourself investing. In order to save on fees, anyone with a balanced fund should consider switching part of their investment into a pure equity fund and investing the remaining bond portion themselves.

Most investors are familiar with Canada Savings Bonds and guaranteed investment certificates (GICs) offered by banks and trust companies. GICs are government guaranteed up to a maximum of $60,000 in one institution as long as the term is five years or under.

But provincial government and corporate bonds usually have higher yields and are worth investigating. Investors can get a good idea of what kind of bonds are available and their yields by consulting the bond tables carried in financial newspapers.

Recently, Government of Canada five-year bonds were yielding around 3.8 per cent. Ontario bonds for the same term were about 4.05 per cent. Top-quality corporate bonds were only a little higher than provincials, but car company bonds, such as General Motors Acceptance, still regarded as investment quality, were yielding around 5.5 per cent.

Of course, some company bonds have yields up around 10 per cent or higher because they carry a substantial risk of default. However, individuals should generally stay away from investing directly in these unless they have enough money to be properly diversified in at least 20 issuers.

The one time it may make sense to invest in a bond fund is if the fund specializes in such high-yielding corporate bonds, also known as Ďjunk bondsí. Such funds give investors the sufficient diversification to keep down the damage should a company default or go bankrupt.

Strip bonds are ideal for RRSPs. Strips are coupon or principal payments split off from a regular bond. The return is the difference between the price at which the strip is bought and what is returned at maturity (100). One attraction is that strips are low-maintenance, since there is only one payment to the investor at the maturity date. There are no regular interest payments that must be reinvested.

But strips also can be more volatile in price than regular bonds. If interest rates rise sharply, a strip bond would decline in price much more than a regular bond of the same term to maturity. In such circumstances, the short-term performance of the portfolio would be significantly hurt, even though the investor would still get the same amount at maturity.

Those concerned about inflation may want to consider real return bonds. Government of Canada real return bonds maturing in 18 years recently were quoted at a 2.6-per-cent real yield, to which one would add the annual inflation rate to get the total yield. While real return bonds will enhance a portfolio in the event of escalating inflation, they will also work in reverse Ė namely, dragging down a portfolio if there is deflation.

Bond fund managers use a laddering approach to their portfolios and individual do-it-yourself investors would be wise to follow this lead. A ladder involves splitting the bond portion of the portfolio equally into bonds due to mature, say, in one year, three years, five years, seven years and nine years. This works out to an average maturity of five years, which is roughly the same as most bond index funds.

With a ladder constructed in this way, when the one-year bond matures (in one year), an investor would have one-fifth of the original principal for re-investment. This would be invested in a 10-year bond, thereby maintaining an approximate five-year average.

This strategy essentially relieves investors from having to make predictions on interest rates. If interest rates go up, there is money coming available to take advantage of the higher rates.

Since most bonds arenít traded on an exchange, pricing information is not easy to get. Newspapers fill the gap to some degree. A couple of independent online sources also exist. For a monthly fee ranging from $12 to $50 a month, investors can see intra-day pricing on hundreds of bonds at www.ebond.ca or www.canpx.ca.


Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff