Fees impact bond risk & return

By Dan Hallett, CFA, CFP on August 10th, 2010

Many financial advisors say that I harp too much on fees.  Many investors (and investor advocates) say that I’m not tough enough on fund fees.  Sometimes, I just can’t win.  But nowhere are fees more important than in the selection of bond exposure.  Whether choosing a bond mutual fund, bond ETF or direct bond investments for fixed income exposure, total costs are paramount in the selection process.  Every point saved in fees adds to total returns over time.  Keeping a lid on fees can also help keep the risk/return profile from getting too skewed against you.  Let’s use an actual bond to illustrate.

According to www.pfin.ca – accessed on August 5, 2010 – a British Columbia bond maturing on December 18, 2018 with a 4.65% coupon traded at $107.45 per $100 of par value.  I calculated its yield-to-maturity at 3.64% per annum and its duration at 6.95 years.  Recall that duration allows you to estimate the price impact of a bond.  With our BC bond, a 1 percentage point rise in the bond’s yield will cause this bond’s value to fall by 6.95 percent – and vice versa.  This is an estimate based on today’s information.  As the bond approaches maturity, its duration will fall as will the price impact of yield changes.

Armed with this information, we can calculate an admittedly crude risk-return ratio:  Duration / (percentage yield x 100)

The idea is to look at the downside risk, over a one-year period, assuming a 1 percentage point rise in rates, compared to upside potential.  Applying the above formula to this bond, we get a risk-return ratio of 1.91 (6.95 / [0.0364 x 100] ).  In other words, this bond’s downside exposure is nearly double its return potential.  The lower the number, the better.  The table below shows my calculations of yield-to-maturity, duration and this risk-return ratio at different levels of annual fees or MER for this bond.

0% MER 1.0% MER 1.5% MER
Yield-to-Maturity 3.64% 2.62% 2.11%
Duration (years) 6.95 7.21 7.35
Risk/Return Ratio 1.91 2.75 3.48

Two observations.  First, the MER reduces the yield-to-maturity by slightly more than the stated level.  This is due to the compounding impact of fund fees, which are typically charged daily and paid monthly.  Second, fees also nudge duration up because they increase the length of time before the purchase price of the bond is recouped.  In other words, fees slightly increase duration risk while also slicing into returns.  The result is a double-whammy impact on our risk-return ratio.

A 1% annual fee is on par with the very cheapest bond funds including compensation for financial advisors.  More typically, fees land closer to 1.5% annually for load bond funds.  If you use a bond ETF, you’ll have to include the MER, advisory fee, bid-ask spread, NAV premium/discount and trading commissions in your annual cost calculation.  Effective fees for direct bond investors include advisory fees and the yield give-up on smaller bond trades (relative to the larger trades executes by funds and ETFs).

However bond fees are incurred, the above table shows how the risk-return ratio worsens as fees rise.  I’m not in the business of forecasting the timing, direction and magnitude of interest rate changes – so I won’t try.  But this simple risk-return ratio may paint a more complete picture of the impact of fees on bonds.