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Bonds or bond funds? The jury is still out

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Individual investors seeking better returns amid today's low interest rates should consider buying bonds outright instead of in a fund, said Hank Cunningham, senior vice-president and director of fixed income at First Associates.

"One thing about bond funds is they never mature -- bond fund managers are always tinkering with their portfolios, extending term, shortening term, and for all of this they're charging an exorbitant management expense ratio," Mr. Cunningham told Report on Business Television during a debate on bond buying.

Management expense ratios often cost more than the trading fees to set up a laddered bond portfolio of $50,000 or more, Mr. Cunningham said.

However, a major downside of buying bonds outright is a lack of liquidity when making future asset allocation decisions, said James Dutkiewicz, vice-president of fixed income and portfolio manager at CI Mutual Funds. Since interest rates are likely to rise in coming years, the fees will be proportionally lower than a fund's return.

However, yields on existing bonds will increase in tandem with rates, causing their prices to fall, which can bode ill for bond fund managers who are actively trading their portfolio and not holding to maturity.

Even so, there are benefits to holding bond funds now, Mr. Dutkiewicz said. Investors can invest incrementally in a bond fund, as opposed to waiting to save up to buy bonds, which can have a face value of $1,000 or more, he said. As well, individual investors need to be careful they aren't charged large markups for their comparably small trades, he said.

"The major downside, especially for younger investors, is a lack of diversification with holding individual bonds," said Mr. Dutkiewicz. "What ends up happening a lot in retail land is they end up getting advice from their advisers and they end up with a significant overweighting in car paper, Air Canada, Bombardier, just to name a few recent blow-ups."

© 2007 The Globe and Mail. All rights reserved.

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