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Bonds set for low returns but still necessary in RRSP portfolios

by Wayne Cheveldayoff, 2005-01-20

With interest rates still on an upward path, don’t expect to get much of a return from bonds in your RRSP in 2005.

But don’t avoid them; think of bonds as a form of insurance to provide some stability in your RRSP portfolio in case things go horribly wrong in equity markets.

Bond mutual funds produced decent annual returns for investors for many years as interest rates fell (causing bond prices and the unit prices of bond mutual funds to rise). Bond funds as a group, according to GlobeFund, produced an average annual return of 8.75 per cent in the past 20 years.

But things have changed. Interest rates have been edging upward and the return for bond funds as a group in the year to December 31, 2004 was only 5.6 per cent.

If, as many economists expect, bond yields continue to rise in 2005, bond prices will be edging lower and the resulting capital losses may be large enough to overwhelm the expected coupon payments.

For example, if the yield on the 10-year Government of Canada bond (with a 5-per-cent coupon) rose from its current level of 4.25 per cent to 4.75 per cent by the end of 2005, the price of the bond would fall by around 5.5 per cent. Such a decline would wipe out the 5-per-cent coupon payment for the year, providing the investor with no return at all.

Some bond portfolio managers may be attempting to mitigate the impact of rising interest rates by shortening the average term to maturity in the portfolio. The prices of short-term bonds decline less than the prices of long-term bonds for a given increase in interest rates.

It’s a strategy that individual investors can adopt. For those investing directly in bonds in their RRSPs, the best choice in a period of rising rates is a short-term bond, with a term to maturity of 5 years or less. Yes, the yield to maturity would be lower (two-year Government of Canada’s yield around 2.95 per cent and five year approximately 3.6 per cent) but the short-term price deterioration from rising rates would also be less.

Bond price-yield calculations are complicated and require a special financial calculator. Investors can do their own scenario calculations using a bond calculator provided at www.tdwaterhouse.com (under Planning and then Investment Basics).

For investors doing their own bond investing, the main benefit is saving on the management expense ratio (MER) charged by bond funds, which is usually in the range of 1.5 to 2 per cent and a sizeable drag on returns.

However, for those wanting exposure to higher-yielding corporate bonds, a bond fund would continue to make sense since one should have a diversified portfolio of at least 20 different issuers to minimize the impact of a possible default or two. Most bond funds have a combination of government and corporate bonds but some are specialized and invest only in high-yield corporate bonds.

Investors looking to save on fees may want to consider the recently introduced Barclay’s iUnits Canadian Bond Broad Market Index Fund, which is an exchange traded fund (ETF) listed on the Toronto Stock Exchange under the symbol XBB. The fund, with an annual MER of only 0.3 per cent (making it the cheapest of all diversified bond funds offered in Canada) is designed to replicate the return of the Scotia Capital Universe Bond Index, which covers the full range of corporate and government bonds with maturities from one to 30 years.

The Scotia Index has a solid record of outperforming most bond funds, since it doesn’t experience the MER drag on bond fund performance. GlobeFund data shows the Scotia Index increased by an average annual 9.03 per cent in the 10 years to the end of 2004, compared with 7.59 per cent for bond funds as a group.

In the past year, the Scotia Index was up 7.15 per cent, whereas the group of bond funds returned only 5.6 per cent on average. Popular bond funds like Mackenzie Sentinel Bond (MER 1.7 per cent) returned 5.14 per cent, CI Canadian Bond (MER 1.74 per cent) 4.69 per cent and Trimark Canadian Bond (MER 1.28 per cent) 6.43 per cent.

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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©2005 Wayne Cheveldayoff