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Weekly Insight

Frugal Fixed Income – PH&N Bond Fund

By CARL WOLFE

Tuesday, July 29, 2003

Most Canadian bond funds invest primarily in staid but secure Canadian government bonds and add value through smaller holdings of higher-yielding corporate issues. High-yield bond funds provide an alternative that focuses on corporate issues. Corporate bonds come with higher risk, but also with greater potential returns. A third income-producing option is the new class of income trust mutual funds. It is important for investors to understand that income trusts carry much greater risk than bonds.

The benchmark against which returns of investment grade debt are generally measured is the Scotia Capital Markets Universe (SCMU) index, which tracks the performance of over 900 Canadian bonds. This index is very difficult to beat on an after-cost basis. Indeed, over the past ten years the average Canadian bond fund returned an average of 6.8% annually. The index on the other hand yielded 8.4%.

The past twenty years have seen domestic interest rates come down from historic highs reached in the early eighties to the lows of today. The result has been remarkable bond market performance that kept close pace with equities. This is a peculiarity of the recent history of Canadian interest rates and is unlikely to be repeated. Furthermore, with rates more likely to increase than decrease, investors' expectations of fixed-income returns must be tempered.

Since bond funds generally underperform the SCMU benchmark and are expected to have lower returns going forward, cost becomes a very important consideration. The median management expense ratio (MER) for Canadian bond funds is 1.64%, though individual MERs go as high as 3%. For high-yield bond funds, which focus on riskier corporate issues, the median is slightly higher at 2.0%. Frugal investors should stick to bond funds that charge an MER of no more than 1%.

Fortunately there are a number of high-quality, low-cost bond funds available. These include funds offered by Phillips, Hager and North, McLean Budden, and Leith Wheeler. Vancouver-based Phillips, Hager, and North (PH&N hereafter) is mainly a pension fund manager. However, they also offer mutual funds that are very attractively priced. The PH&N Bond Fund, which is the focus of the rest of this article, offers conservative management with a
very enviable track record for the rock-bottom cost of 0.58%.

Over the past twenty years, the PH&N Bond Fund returned an average of 10.5% annually, just slightly underperforming the SCMU index which yielded 10.6%. The fund has consistently kept pace with the index since its inception in 1970. Over the last year, as domestic interest rates reached a bottom and began to rise, the fund gained 9.4%, beating the index's 9.1% return. Income distributions to unitholders accounted for over half of the one-year return.

Managed by Scott Lamont, a member of the PH&N fixed-income team, the fund invests mainly in government and high-yield corporate bonds rated BBB or above (using the Dominion Bond Rating Service scale). It also buys Canada Mortgage and Housing Corporation backed mortgages. Having exposure to a wide variety of issuer classes is but one facet of the fund's active multiple strategy approach. Interest rate and yield curve strategies are also used, which reflects Mr. Lamont's belief in strategy diversification as the best way to add value over the long term.

A core of Canadian government bonds representing no less than 30% of assets provides the fund with liquidity and ensures a minimum credit quality level. A highly diversified portfolio of carefully selected corporate bonds, on the other hand, serves to enhance the fund's yield. Indeed, the corporate sector has been a main focus of the fund's recent strategy, and the fund is currently overweighted in that category. Corporate bond selection relies on both top-down economic analysis, and bottom-up analysis of specific issuers and bonds. Throughout the process the fund's emphasis is on controlling risk and avoiding making any "big bets".

Illustrating its active management style, the fund began the first quarter of 2003 with a 15.6% cash position. However, by the end of the quarter that had dropped to 1.7% as the fund deployed its cash. Roughly two thirds went to purchasing federal government bonds, while the balance was mainly invested in corporate issues. At the end of the first quarter, the fund held 122
securities. Of these, nine were Canada bonds making up 43.4% of the portfolio and ninety-one (or 33.3%) were corporate bonds. The single largest corporate
issue was a 4.35% GE Capital Canada Funding Company (GE) bond maturing in February 2006 representing a little over 2% of assets and rated AAA. The
portfolio's effective yield was a healthy 5.3%.

In terms of maturities, the fund trimmed its short-term holdings during the quarter in anticipation of interest rate increases and ended up with a structure, which favours medium-term bonds. Issues with between one and ten years to maturity made up 53% of the portfolio, and the average term was 9.7 years. However, the fund's overall sensitivity to interest rates increased only slightly, continuing a long-term trend.

Over the past twelve months, which saw an end to the domestic
bond market rally, the portfolio's aggregate properties remained fairly stable. The fund's components, however, were not static. Until this past quarter, federal government holdings had been steadily pared back while cash reserves increased. At the same time the fund continued to increase its exposure to provincial and corporate bonds. These shifts had the effect of decreasing the portfolio's share of AAA-rated bonds. However, a corresponding drop in the
number of BBB-rated bonds helped ensure that overall credit quality remained essentially unchanged.

One slightly negative aspect of the fund's active management style is its high turnover. Over the past five years turnover has
been on an upward trend and averaged 287% per year. Mr. Lamont states that this is an expected side effect of the fund's emphasis on multiple strategies. Although it has not prevented the fund from outperforming its peers, the recent trend is a source of concern as it represents increasing brokerage costs that
are not reflected in the MER.

It is worth pointing out that the PH&N Bond Fund's 0.58% MER is not only lower than that of most of its actively-managed peers, it is also lower than that charged by most bond index funds. For a minimum investment of $25,000 the fund is available to all investors either directly through Phillips, Hager & North (800-661-6141 or 604-408-6100), or through dealers. A rock-bottom MER combined with a superb long-term performance record makes the PH&N Bond Fund a bargain and worthy of inclusion in conservative portfolios.

Remember that bonds are expected to underperform equities over the long term, recent Canadian history notwithstanding. Also, in the near term, rising interest rates will limit bond funds' upside potential. Therefore, now more than ever, it is crucial to select low-fee, fixed-income funds.