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Smart ways to invest in bonds in your RRSP

by Wayne Cheveldayoff, 2006-02-23

It is definitely a good idea to have bonds in your RRSP to provide regular income or to balance out the risks of holding equities. But many Canadians make costly mistakes in how they invest in bonds.

The “hand-in-your-pocket” TV ads definitely apply to the advice on bond investing that most banks and investment advisors provide.

Investors are usually encouraged to own bond or balanced mutual funds. The problem is that the annual mutual-fund management fees, which benefit the advice-givers, draw away a substantial amount of the annual return to investors.

Take, for example, the Talvest Bond Fund, which Globefund.com says returned 5.32 per cent annually in the past 10 years. The fund has an annual management expense ratio (MER) of 2.12 per cent, which is approximately the amount by which it lagged the Scotia Capital Universe Bond Total Return Index, which had an annual return of 7.49 per cent over the decade.

In the case of balanced funds, bonds are mixed in with equities. Yes, it is a convenient, one-fund solution to having a balanced portfolio, but the high MER is applied to the bond component as well as the equity component.

A good example is the Fidelity Canadian Balanced-A Fund, with its 2.36-per-cent MER applying to its 45-per-cent holding in bonds. With Canadian yields for high-quality bonds in the 4-to-5 per-cent range, almost half of the expected yield-to-maturity on the bonds is being drained away by fees.

Unfortunately, Canadians choosing bond or balanced funds may be attracted by the decent long-term returns. However, historical bond returns were boosted by capital gains on bonds as interest rates fell gradually over the years. With interest rates expected to be stable or to rise slightly in the future, investors should expect only the coupon return on bonds and that makes it all the more important that fees be minimized.

The smart approach, therefore, is to invest directly in high-quality bonds (or GICs). This is fairly easy to do. One can replicate the work of a fund manager simply by buying a package of bonds known as a bond ladder (one bond maturing in each year for the next 10 to 15 years).

The only time it makes sense to use a bond fund is when you want to invest in high-yield, risky corporate bonds. Studies show you need to diversify into 20 such bonds in your portfolio to effectively insulate against a bankruptcy or two, and unless you have a very large portfolio, this can only be achieved through a fund.

One can also easily own real return bonds directly. These inflation-protectors are ideal for an RRSP since they provide a real return, currently about 1.5 per cent, plus the rise in the CPI.

For anyone preferring instead the simplicity of a fund for their core bond holding, the best choice would be one of the iUnit exchange-traded funds (ETFs) offered by Barclays Global, given their low MERs of 0.35 per cent a year or less.

Barclays offers the iUnits Short Bond Index Fund (symbol XSB on the TSX), which mimics the Scotia Capital Short Bond Index, the iUnits Canadian Bond Broad Market Index Fund (XBB), which replicates the Scotia Capital Universe Bond Index, and the iUnits Real Return Bond Index Fund (XRB), which approximates the return of the Scotia Capital Real Return Bond Index.

Even these low-fee funds, however, can’t provide the benefits of owning strip bonds in your RRSP. Strips, also known as zero-coupon bonds, are bond principal and coupons sold separately and the advantage is not only convenience, since you don’t need to reinvest coupon interest each year, but also the insurance factor.

If stock markets fall apart, bond yields would likely eventually decline and the resulting capital gains in bonds would offset losses on equities. In the case of strips, a decline in yield produces a bigger capital gain.

For example, if a regular 10-year bond (with a 4-per-cent coupon) drops in yield from 4 to 3 per cent, the capital gain would be 8.8 per cent. The same yield decline for a 10-year strip would produce a 10.5 per cent capital gain. For a 30-year term, the gain would be 17 per cent for a regular bond versus 34 per cent for a strip.

You can work out any comparative scenario you please using the bond calculator at www.smartmoney.com.

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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©2006 Wayne Cheveldayoff