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Low interest rates simplify choices for bond fans

Picking a winning fund has become easy - just look for the ones with the lowest fees, experts say

You don't need to be a market expert to pick a top performing Canadian bond fund to invest in these days.

That's because the single biggest indicator of how a generic bond fund will perform these days is something we all understand - the size of its management fee.

The bond funds with the lowest management expense ratios (MERs) tend to have the best total return in their class, says Philip Lee, fund analyst with Morningstar Canada. The company has found a strong negative correlation between the size of a fund's fee and its total return to the investor, which is the performance of the investments in the fund, minus the fee.

That's because now, more than ever, returns on bond funds are razor-thin, because of ever-lower interest rates, and the spread between short- and long-term government bonds is relatively small, meaning that aside from buying riskier corporate debt, there are limited ways these bond-fund managers can make their returns stand out.

For individual investors, this makes the job of picking a fund a little easier.

"For the average investor, look for a product that offers you some diversification, a good manager and a low fee," Mr. Lee advises.

He likes two funds by Phillips, Hager & North that each have low MERs: the PH&N Bond Fund, and the PH&N Total Return Bond Fund. Each fund's MER fees are 0.59 per cent, with five-year annualized returns of 5.5 per cent and 5.8 per cent, respectively, as of Jan. 31.

Mr. Lee also likes the TD Canadian Bond Fund (investor class) for its 1.06-per-cent MER and 5.3-per-cent five-year annualized return, compared with 4.5 per cent for the median fund in this class.

On the other end of the spectrum, some Canadian bond funds have such high MERs that after taxes and fees are paid, there is little left for the investor.

For example, Radiant Bond Portfolio, sponsored by Dynamic Funds, has a MER of 2.5 per cent and a three-year return of 2.2 per cent, according to Similarly, AGF Canadian Bond fund has a MER of 1.86 per cent, and a one-year return of 2.8 per cent, and a five-year return of 4.1 per cent.

The average MER for funds in this class is 1.42 per cent, and average total return last year was 2.3 per cent, according to Morningstar. By comparison, Canada's DEX Universe Bond Index rose 3.7 per cent last year.

But it's not only about fees, of course. In these changing economic times, investors would do well to research the prowess of the individual manager behind the fund, Mr. Lee says.

"Start looking at a track record of a manager and how they've handled economic cycles," he says. "The market is still working out the jitters, the markets are still on a very touchy and fragile surface right now.

Investors should take their time to look for a fund that fits their style."

Investors have sought the haven of government bonds for several quarters now, as equity markets and certain corporate debt markets have seen dark days. To stimulate their respective economies, the Bank of Canada and the U.S. Federal Reserve are each expected to cut interest rates this year, making existing bonds with comparatively high interest rates even more expensive than they are now.

As the price of a bond rises, its yield, or the amount the fixed interest payment is worth relative to the price, falls. Mark Chandler, a fixed income strategist at RBC Capital Markets Inc. in Toronto, predicts bond prices will remain expensive for fund managers to buy until midyear.

Two-year bond yields will end the year at about 3.25 per cent, Mr. Chandler predicts, whereas they are sitting at about 3.04 per cent now. He believes that yield will fall lower before climbing toward year's end, as benchmark rates are cut by the Bank of Canada and the Fed.

He expects the bank of Canada to cut its current 4-per-cent target for overnight loans between banks by another percentage point by about midyear, and he predicts the Fed will also cut its 3-per-cent fed funds rate by that much. Mr. Chandler expects the benchmark 10-year bond to end the year at 4.10 per cent, from its current level of about 3.80 per cent.

For now, short- to mid-term Canadian government bonds are the best defensive play for fund managers, though they're not going to make anyone rich, Mr. Chandler notes.

"It's not a question of finding a superstar here, but one that will hurt you least," he says.

One way to diversify your fixed income holdings for now is to look at some types of global bond funds, Mr. Lee says. With the Canadian dollar's appreciation, most of the global funds have lost money in recent years, which is why it's a good idea to go for one that hedges out currency risk, such as RBC Global Bond. With a MER of 1.75 per cent, investors get exposure to bond markets in other countries; over the past five years, the fund returned 3.3 per cent annually, whereas the median return for this fund class was a loss of 1.3 per cent per annum, Mr. Lee notes.

"Generally they are hedged back to Canadian dollars, but they are permitted to make a call on a currency," he says. "Hedging the funds back to Canadian dollars has certainly helped this fund, the Canadian dollar has just been so strong over the last couple of years."

Theresa Ebden is a producer for Business News Network.

© 2007 The Globe and Mail. All rights reserved.

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