November 21, 2007

Bonds vs. bond funds
Needs, amount, fees drive decision

Numerous articles over the years have been written on the merits (or lack thereof) of bond funds. Cost-conscious advisors and analysts have long argued that direct bond exposure is the most efficient way to invest in bonds. This is true in some cases, but it's not always that clear cut. A handful of factors should influence your chosen path to gaining bond exposure.

Income needs

Investors in need of monthly cash flow from their bonds will have to use a fund unless they hold enough bonds to smooth out each one's semi-annual interest payments. Bond fund management plus financial advisory fees should ideally be no more than 1% per year - or 0.75% for investors buying funds without an advisor. With long-term Canada bonds still yielding just 4.25%, fees are critical. And be careful when researching funds online. Some funds with ultra-low management expense ratios carry additional fees (i.e. wrap fee) or are not widely available (i.e. MD funds).

Buying enough bonds directly to generate a relatively smooth monthly income requires a minimum of six bonds and at least $10,000 should be invested in each. So, the absolute minimum for a direct bond portfolio for monthly income seekers is $60,000. But if you're buying anything other than federal or provincial government bonds, the minimum should be many times higher and funds may be the best option.

Exposure type

Investing directly in bonds is best suited to federal or provincial government bonds, where diversification is of little importance. With stock investing, if you buy a single stock you live and die by the fate of that stock. So, you diversify to prevent any one company's troubles from crushing your portfolio. But if you're buying government bonds, the risk of default can't be diversified away, except by buying bonds issues by non-Canadian governments or by simply investing in another asset class. The risk of default is sufficiently low that the primary concern is interest rate risk.

In this case, buying a single bond with a duration matching the desired level of interest rate risk is a good way of obtaining bond exposure. Another strategy, called immunization, involves matching a bond's duration with the investor's time horizon to provide a defined lump sum at some specific future date.

If corporate bonds are desired to boost yield, I urge you not to buy bonds directly. A lack of liquidity, larger investment minimums, need for diversification, and features requiring more complex analysis (i.e. embedded options) are good reasons not to bother buying corporate bonds directly. There are some good corporate bond funds available, including a relatively new Barclays exchange-traded fund.

Fees

Investing directly in bonds (or even bond ETFs) gets really expensive when investing small amounts of money or when trading even moderately (because of bid-ask spreads on bonds and brokerage fees for ETFs). The way to maximize the benefits of direct bond investing is to minimize costs, which is done by buying high-quality liquid bonds and holding them to maturity.

As noted previously, bond fund managers have relatively little potential to add value, so you should not be willing to pay much for a broad market bond manager. With bond funds, cheaper is almost always better. This is a rare example in the fund industry where simply sorting today's bond funds by MER is almost always a sure winning strategy. Accordingly, advisors (and clients dealing with advisors) should take a close look at PH&N's new B series of bond funds, which pay 0.25% per year in trailer fees.

This strikes a nice balance between keeping a lid on costs while providing some compensation to advisors.

Other factors

Notwithstanding all of the above, three things should be kept in mind.

First, with yields on high interest savings accounts hovering around 4% annually, such vehicles allow investors to capture most of the current yield offered on longer bonds without the interest rate risk. Second, direct bond investing suffers from what I call 'cash slippage'. Let me give you an example.

The Government of Canada bond maturing March 1, 2011 closed recently at a price of $114.21 per $100 of maturity value. The smallest amount you can buy is $5,000 worth of maturity value, which requires $5,710.50 today to buy those bonds (114.21/100 x $5,000). Unlike a mutual fund, you cannot buy a specific dollar amount of a bond issue.

Like stocks, you buy a certain number of securities and you invest whatever dollar amount the purchase price and number of securities works out to. So, direct bond investors almost always have extra cash left over, and semi-annual coupon payments usually can't be efficiently reinvested directly into bonds. I view this as an indirect cost, or opportunity cost. But this 'slippage' can be minimized by simply reinvesting interest payments and any left over cash into a reasonably priced bond fund.

This issue of bonds vs. bond funds is not nearly as straightforward as it seems so make sure to weigh the above factors, in addition to any other client-specific issues before deciding which path to bond exposure is best.