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Even stodgy bonds can take nasty bite in twitchy market

Things are so twitchy in financial markets these days that even a run-of-the-mill bond fund can rear up and bite you.

That's what the $1.8-billion Royal Bond Fund has done to its unitholders recently.

The Royal Bank of Canada fund lost 2.9 per cent in the 12 months to Oct. 31, which makes it the third-worst performer among Canada's 118 bond funds over that time period.

No, this loss isn't catastrophic, and it's not nearly so bad as the average loss of 6.8 per cent for Canadian equity funds.

Still, Royal Bond's problems warrant a close look because they highlight the unanticipated risks you can run into even when investing in comparatively benign things like a bank-run bond fund.

Bond funds haven't been outstanding in the past year, delivering an average return of 2.6 per cent. Still, Royal Bond was the only widely held bond fund to lose money over that period, and one of only seven bond funds to have been in the red, period.

"For a bond fund to have lost money in the past year is a curious thing," said Dan Hallett, a fund analyst with Sterling Mutuals in Windsor, Ont.

The bond fund category in Canada is dominated by bank fund families and Royal Bond is second-ranked by assets behind TD Canadian Bond. Royal Bond's performance has often slipped below the average in recent years, but not so glaringly as in the past year.

You won't find any clues about what went amiss in the fund's Top 10 holdings, which are as generic as you get in the business of running a bond fund. For the real story, you have to go back to last April.

Back then, it appeared to some observers that interest rates in North America were about to run higher. Royal Bond's managers responded by positioning the fund in such a way that it would protect unitholders from the bite of higher rates.

Problem is, rates didn't rise. They fell, sharply.

"We made a call on interest rates earlier in the year and we were wrong," said Jim Davis, lead manager of Royal Bond since February, 2000.

At the time that Mr. Davis and his team identified the higher rate threat, the government bonds held by Royal Bond had an average duration of about eight years.

Shorter-term bonds provide a better shelter when rates are rising, so a decision was made to use futures contracts to shorten the duration of Royal Bond's portfolio.

A plain old bank bond fund using derivatives? You bet.

The prospectus for Royal Bond clearly states that the fund may use derivatives as permitted by securities regulators. Promotional material for the fund includes derivative risk as one of eight types of risk associated with Royal Bond.

This may sound surprising, but there's nothing unusual at all about a bond fund using derivatives, said Mr. Hallett, the fund analyst.

"I would say that it's certainly within the mandate of some, if not all, bond funds," he said. "The futures market is a cost-efficient, expedient way to shorten the duration of a bond portfolio."

Part of the fallout from Royal Bond's slump was the suspension of a monthly income distribution starting in June. Mr. Davis said Royal Bond has had to halt distributions before, so this isn't exceptional. He also noted that Royal Bond does not emphasize its monthly distributions, as do other RBC funds.

Still, shutting off distributions has to be an irritant to unitholders hoping to benefit from an overall investing environment that was not unfavourable to bonds.

Mr. Davis said he anticipates the distribution will be restored in the new year as fund performance rebounds. The fund has already shown signs of life. It eked out a gain of 0.04 per cent in October while the average bond fund lost 0.44 per cent. In November, the fund has risen about 0.94 per cent.

"We're certainly heading in the right direction," Mr. Davis said. "Interest rates have seen their lows and we think that they're poised to move higher. We don't think we're going to see a quick move to higher interest rates, but certainly over the next 12 months we think our strategies are going to prove to work out very, very well."

If Mr. Davis is right, then the past year will go down as an unfortunate glitch for Royal Bond, and a lesson to investors that even a bond fund carries risks.

© 2007 The Globe and Mail. All rights reserved.

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