Bulked up bond funds
Equities boost bond fund returns

Some of Canada's smaller bond funds - which admittedly make up a small subset - have started bulking up. No, the managers aren't hitting the weights. Rather, a growing contingent among bond funds is attempting to juice returns by holding positions in stocks and income trusts. Throughout, my use of the word "equities" refers to the total of stocks and trusts.

Offenders

Using Morningstar Canada's Paltrak software (as of July 2004), there are 377 mutual, segregated, and pooled investment funds in the Canadian bond, Canadian short-term bond, and Canadian mortgage categories. Of these, three-dozen hold positions in equities or trusts, and twenty funds with weightings of at least 5 percent ranging as high as 50 percent.

Desjardins' Millennia III Mortgage Series 3 and Series 4 segregated funds carry a name, and are placed in a category, that bears no resemblance to its content. They look more like balanced funds with a 50 percent weighting in domestic and foreign common stocks. Interestingly, the Canadian Investment Funds Standards Committee (CIFSC) even ranks it among the twenty-two mortgage funds tracked by IFIC.

This, despite the CIFSC's Mortgage Fund criteria that a minimum of "... 70% of the market value of the portfolio must be Canadian industrial, commercial and/or residential mortgages, including mortgage-backed securities. A minimum of 50% of the fixed income section of the fund must be in mortgages or mortgage-backed securities."

In spite of the industry's best effort to better define classifications, there remain some shortcomings, not to mention the inappropriate titles still lingering on some of the industry's products.

Three more segregated funds - London Life Income (MF), Great-West Life Income (M) A, and Great-West Life Income (M) B - all managed by Mackenzie Financial, are the next worst offenders with 38 to 39 percent weightings in stocks and trusts. All three funds - in addition to London Life Income (LLIM) with 1/4 in equities - are included among Canadian Bond funds according to CIFSC.

Other funds from SEI, Counsel, Northwest, and Acuity are among so-called bond funds with significant holdings in equities.

Implications

If advisors and investors do their homework, such funds can be avoided; or at least they can be purchased with full knowledge of their tendencies to hold equities. Online information from Globefund and Morningstar Canada can be very useful in this regard, though neither allows a way to screen for such things. The obvious implication is that a fund believed to offer fixed income exposure - and the relative stability that comes along with such exposure - can really throw an otherwise solid asset allocation strategy right out the window.

Those so-called "bond funds" with substantial holdings in foreign stocks will also expose investors to greater currency risk that one may otherwise think they had. Further, given that many of these cheating bond funds are segregated funds, it makes little sense to look to insured funds for bond exposure; particularly when buying a bond directly can not only guarantee principal, but also provide a guaranteed return if held to maturity.

Advice

If a bond fund outperforms the index by more than just a fraction of a percentage point, it's likely that the fund is getting exposure to securities outside of the bond universe. That also means that it's assuming risks that are outside of the bond universe. The performance versus the index is a good first screen. The obvious answer to keeping such funds out of portfolios is to simply look beyond a fund's label. A fund's offering document and some quick web research will usually give you the required information.