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As recession fades, so do bond returns

Past performance is not indicative of the profits to expect from these funds in the future

rcarrick@globeandmail.com

Stop buying bond funds.

Really.

They're not as safe as you think they are, the return potential looking ahead is poor and there are better options out there. What else? Oh yeah - they're also among the most over-priced products in the fund universe.

Bonds were impregnable during the worst of the financial crisis and that's obviously how people see them in today's improved but still uncertain market environment. That's why bond funds have been hugely popular this year.

To be precise, bond funds have mostly played No. 2 to balanced funds on the monthly sales charts this year, with both categories vastly ahead of funds that hold only stocks. But after topping the sales charts last month, bond funds obviously have momentum.

Stop buying them, would you?

Unless your exposure to the stock market is excessive and you need them to balance your portfolio, bond funds are a dead end right now.

"Barring renewed recession, it's too late to pile onto the safe haven bandwagon," CIBC World Markets said in a report released Wednesday.

Avery Shenfeld, the firm's chief economist, said a couple of conditions are needed for bonds to do well in the months ahead. Either the Bank of Canada has to stop raising interest rates and remain on hold for an extended period of time, or inflation has to continue to melt away.

Neither has much of a chance of happening in Mr. Shenfeld's view, and that suggests hard times for bonds.

"There's little prospect of a rally here, so the odds are that yields begin to rise and bond funds perform relatively poorly," he said.

Bond funds hold portfolios of government bonds and, sometimes, some corporate bonds as well. When interest rates fall, as they did when the financial crisis hit, bond prices rise, bond yields fall (prices and yields always move in opposite directions) and bond funds look great. And when rates rise? Bond prices fall, yields rise and bond funds can lose money. The reference year for bond funds losing money is 1994, when the average loss was 5.4 per cent.

The one thing that can help bond funds do well in the months ahead would be a return to recession. Mr. Shenfeld is predicting slow economic growth here in Canada and in much of the world, but he doesn't see a return to recession.

"We do have a slow-growth environment, but I don't think we have any tell-tale signs of recession yet," he said.

The worst mistake you can make in rationalizing the purchase of a bond fund right now is to look at past returns. Canadian bond funds have average returns of 6.7 per cent in year to Aug. 30, and 5.8 per cent annually over the past three years. Looking forward, it's hard to see returns that good.

There are two components to bond fund returns - the interest paid on the bonds they hold and capital gains or losses on the bonds in the portfolio. Even if bonds are falling in price, you still have the interest income.

But with interest rates as low as they are the amount of income you get from bonds is very low. The yield on the DEX Universe Canada Bond Index, a good benchmark for comparing the typical bond fund, is about 2.9 per cent these days. For real-life yield numbers, you have to subtract the fees charged by bond funds to investors who own them.

The average management expense ratio on bond funds ranges from 1 to 1.9 per cent for the most popular products in this category, which leaves you with a yield below 2 per cent.

An alternative worth consideration for income seekers: Dividend stocks and dividend funds. Mr. Shenfeld noted that dividend yields are above five-year Government of Canada bond yields, which is an oddity. The usual deal for investors is to buy a bond and get a higher yield, or buy dividend stocks and get a lower yield, but also the potential for growth through dividend increases over the years and share price gains.

The bottom line reason for buying bond funds is that you're too nervous to buy stocks or equity funds. Mr. Shenfeld's no raging bull, but he does see a flat to slightly higher market in the next year or so. Even that, he says, should beat bond funds.

"It doesn't take much in the way of capital gains when added to the dividend to do a lot better than bonds."

Follow me on Facebook. I'm at Rob Carrick - Personal Finance

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Bond fund facts

$11.1-billion

12-month net sales to Aug. 31

$4.9-billion

Comparable figure from a year earlier

1.71%

Average bond fund management expense ratio (MER)

1.90%

Five-year Government of Canada bond yield

2

Number of money-losing years since 1985 (1994 and 1999)

3%

Average return in 2008

Source: Globeinvestor.com

© 2007 The Globe and Mail. All rights reserved.

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