Bond funds are passé
Fat fees are high hurdle

With interest rates at multi-decade lows and the prospect of rate hikes ahead of us, many are leery of the outlook for bonds. In my opinion, there are good reasons for this gloomy view. However, if that's how you feel about bonds, you should be downright repelled by most bond funds.

Bond yields

It seems that bond yields and interest rates have been historically low for a number of years. As of August 26, 2004 the Bank of Canada reports that yields on short-term bonds (1-3 years to maturity) crept back above the 3 percent level. Mid-term bonds just inched up above 4.4 percent, while long-term yields have held steady just north of 5 percent.

Diversifiying into provincial or (investment grade) corporate bonds can enhance yield. However, the extra yield obtainable from taking incremental credit risk is not as fat as it was a couple of years ago. A search of my discount broker's bond inventory reveals 50 basis points in extra annual yield (over Canadas) for going to provincials and an additional 10-50 basis points for investment grade corporates. However, the higher end of that range is only possible if dancing on the edge of what separates "investment grade" from "speculative" debt.

In short, the gross yields are low (even after accounting for inflation) and the reward available from accepting greater credit risk is below that which has been available historically.

Bond fund fees and past value added

According to Morningstar Canada's Paltrak software, the median bond fund MER is 1.67 percent annually, excluding segregated funds. I further tweaked this list by excluding funds that can't be obtained at their published MER (i.e. SEI, Optima Strategy, etc.) and those that require a minimum investment of $150,000 or more. I also filter out high yield funds, which have a median MER of 2.04 percent. The resulting median MER after running these filters results in a median bond fund MER of 1.87 percent per annum.

A gross yield of 4.4 percent means that the median bond fund starts today with a net yield of 2.53 percent. If the manager can add any value, that could run up a bit but we're still talking about returns in the 3 percent range. Perhaps less, when you consider how bond fund managers have done historically.

Of the 41 Canadian bond mutual funds with a ten-year record through July 2004, just twenty beat the index after the MER was added back to the published 10-year returns. This is an imperfect measure to be sure since only the current MER is used and fund returns include the implicit costs of trading bonds while the index does not. Also, mandates may not have been constant throughout the entire measurement period. However, when less than half of existing funds (excluding those that were closed or merged into the history books) beat their index before fees, it casts some doubt on the ability of bond managers to do so going forward - net of fees.

In case you're interested, just two funds posted ten-year returns (after fees) that topped the index - Altamira Income (which has historically made huge interest rate bets) and TD Canadian Bond (which has a policy of holding investment grade corporates). All others trailed the index.

In other words, today's bond fund investors are starting with a net yield of 2.53 percent. This return can be boosted in two ways.

Either the manager can add value through astute security selection or rate forecasting; and/or interest rates can continue falling. We've seen that an admittedly crude study of the past doesn't bode well for the potential of managers to add value. And, we know at least that rates have less room to fall than they did one, two, five, and ten years ago. Of course, if rates rise that paltry 2.53 percent is sliced further.

Advice for advisors

Returns under 3 percent are unacceptable for the type of risk taken in a bond fund. In fact, that's not much more than is available at ING Direct or other high interest savings accounts. Hence, the challenge for advisors is to find fixed income solutions for clients offering return potential that is reasonably above that of risk-free alternatives.

Direct bond investments or low fee bond funds will maximize the likelihood of realizing sufficiently high returns from investment grade bonds. The problem is that many advisors don't have a securities license, so they don't have access to individual bonds. Those that do through brokerage correspondent relationships may not have such access in the future since regulators seem keen to shut down such arrangements. And cheap bond funds don't pay much, if anything in trailers.

The answer seems clear to me. In order to remain competitive, an advisor must have access to individual bonds. For larger clients, advisors can well afford to place some money with a low fee bond fund.

It may be a cut in compensation overall, but I think clients would see that as fair since their returns going forward from this asset class are getting cut. Being fair to clients isn't always a golden road but it is the path to building and maintaining a solid client base.