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For the unsophisticated, bond funds do the trick

Several products offer a viable alternative to individual securities

Be a schlub - buy a bond fund.

That's how the elitists in the personal finance world think. They say it's much smarter to buy bonds directly than to invest in a bond fund, where high hefty fees erode returns that are already on the scant side because interest rates are so low.

All of this is pretty much true, but it ignores three important realities. One, lots of investors only have access to mutual funds and simply aren't ever going to set up the brokerage account they need to buy bonds directly. Two, small investors often get a rotten deal when they buy their own bonds. And, three, there are several good bond funds that offer a viable alternative to a portfolio of individual bonds.

It's easy to understand why savvy investors think people who buy bond funds are yokels. Frankly, it's scandalous how bad bond funds are in general. Fees are high, returns stink and no one seems to care because, after money market funds, bond funds are the most boring and least glamorous products in the mutual fund industry.

And yet, almost all investors need bonds in their portfolio to cushion the effects of falling stock markets and provide a reliable source of income. No, you won't make as much from a bond over the long term as you would in an equity fund. But for many people, the peace of mind that comes from owning bonds is well worth giving up a small amount of return.

Bond funds are the easiest way to get some bonds in your portfolio because you can buy them pretty much anywhere investments are sold and because the minimum investment can be under $1,000. Bond funds are very democratic, in other words.

Buying actual bonds is much more difficult. You need a brokerage account and, typically, at least $5,000 to invest in each individual bond. You'll also have to pay a commission that is invisibly factored into the price you'll pay to buy the bond. Essentially, your investment dealer will take the price it paid for a bond, mark it up some and then sell it to you.

The problem here for small investors is that every bit added to the price of a bond chips away at the yield (prices and yields move inversely). This explains why people are sometimes surprised at just how low yields are when they buy individual bonds for their portfolio. If you have a large account with a brokerage firm and a good relationship with an adviser, you might well be able to get favourable pricing on bonds. But smaller accounts get taken advantage of, which means they end up with less yield.

This brings us back to bond funds. Every fund company sells them, but few are worthy.

The main problem is the cost of owning bond funds. Fees are such that they reduce the reported returns in the Canadian bond category by an average 1.72 percentage points. To put this in context, the yield on Government of Canada bonds maturing in two to 30 years is just 4 to 4.25 per cent these days.

Fees are a vitally important aspect of fund selection, period. With bond funds, they're arguably the most important factor. The Investors Government Bond Fund, the fifth-largest Canadian bond fund with $2.4-billion in assets, is an ideal illustration. Its 2.01-per-cent management expense ratio is much higher than the category average of 1.72 per cent, and its returns are consistently below average. This is just the sort of bond fund that gives the category a bad name.

Now, let's look at some cheaper, better alternatives. You'll find two types of funds in this group, one of them being exchange-traded funds, or ETFs. Bond ETFs offer the same return as a series of bond indexes maintained by Scotia Capital for measuring returns in the fixed-income market, minus fees that range from 0.25 to 0.35 per cent. Bond ETFs are an effective way to invest in bonds, but they're bought and sold like stocks and thus require a brokerage account. For this exercise, we're focusing on bond funds for people who don't deal with a broker and thus have access only to conventional mutual funds.

The other bond fund alternatives are conventional funds with low fees, which we'll define here as having an MER of less than 1.1 per cent. Almost all of these funds are offered by no-load fund companies that have little or no profile with retail investors because their main line of business is managing money for pension funds and rich people.

An example is Beutel Goodman Income, a fund that tends to beat the average Canadian bond fund by 0.75 to one percentage point thanks to a low MER of 0.76 per cent. Another example is Phillips Hager & North Bond, which has a lower MER and a somewhat better record of outperforming the average peer fund. The drawback with both these funds: The minimum initial investment is $10,000 for Beutel Goodman Income and $25,000 for PH&N Bond.

Don't worry - more accessible bond funds worth owning do exist. One of them, TD Canadian Bond, is the largest bond fund in the country by far and can be purchased with an upfront amount as low as $100. The MER for this fund is somewhat higher than the likes of Beutel Goodman Income and PH&N Bond at 1.07 per cent, but the team of managers running it justifies this with returns that regularly beat the average. In fact, this is one of the few bond funds of any type to offer long-term returns that are very close to the benchmark Scotia Capital Universe Bond Index.

The same group at TD manages the firm's very successful real-return bond fund, which focuses on bonds that offer a premium over the inflation rate. This is a specialty fund that you use to augment your core bond fund holdings. PH&N also offers a good real-return bond fund, while Beutel Goodman offers specialty bond funds that focus on long-term and corporate bonds. These are a riskier than the average bond fund, but they offer the potential for greater long-term returns.

There's a lot of talk right now about how stubborn inflation is proving to be in Canada, and how this may lead to higher interest rates.

This outlook is negative for the bond market and already we've seen it retreat in the past couple of months. The more bonds decline, the more attractive they are to buy for the long term. For many investors, the easiest and best way to do this will be through a low-fee bond fund.

Good values

in bond funds

Here are some bond funds to look at on the basis of their low fees and solid returns. Funds were considered for this list if they have management expense ratios well below average and returns ranked among the top 25 per cent of their categories over the past three- and five-year periods. The funds are listed according to their minimum upfront investments.

If you have $25,000 to invest in a bond fund, take a look at:

Leith Wheeler Fixed Income: A solid offering with an MER of 0.80 per cent, which compares to 1.72 per cent for the average Canadian bond fund.

Phillips Hager & North Bond: The management expense ratio is a very low 0.59 per cent, and returns routinely crush the average peer fund.

If you have $10,000 to invest:

Beutel Goodman Income: An MER of 0.76 per cent and solidly above-average returns over all time frames.

McLean Budden Fixed Income: The MER is 0.65 per cent and returns are dependably good.

If you have lesser amounts to invest:

Mulvihill Canadian Bond: A reasonably low MER of 1.07 per cent and an emphasis on corporate bonds have helped deliver strong returns.

TD Canadian Bond: The country's largest bond fund has an MER of 1.07 per cent, which is high but not so high as to prevent top-flight returns.

TD Canadian Bond Index e: This is a bond index fund - it tracks the Scotia Capital Universe Bond Index - that offers a low MER of 0.48 per cent and can only be purchased online. (There's a regular version of this fund that can be purchased widely with a higher MER.)

Trimark Canadian Bond: This fund's 1.28-per-cent MER is on the high side for this group, but the returns are quite good for a bond fund run by a mainstream fund company.

Bond fund ABCs

WHY OWN THEM

They're an easy way to get the exposure to bonds that almost all portfolios need to varying extents.

THE BENEFITS

Bond funds provide diversification, professional management and they're available to all investors, whereas you need a brokerage account to buy bonds.

THE KNOCK ON THEM

The fees are often so high that they're not worth owning.

THE SECRET TO BUYING THEM

Focus on fees - all the best bond funds have low management expense ratios, while high fees are often the problem with poor-performing funds.

THE ALTERNATIVES

The easiest and arguably the best alternative to bond funds is the bond exchange-traded fund, or ETF, which trades like a stock and mirrors the returns of major bond indexes; other alternatives include holding bonds directly, or guaranteed investment certificates.

THE LAST WORD

Bond funds are often and justifiably ripped for their high fees and weak returns, but there are good ones out there that could be a great stabilizer in your portfolio come the next stock market correction.

© 2007 The Globe and Mail. All rights reserved.

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