Why bonds and GICs are a better fixed-income investment than bond funds: Dale Jackson
The myth that bond funds qualify as fixed income in an investment portfolio should finally be put to rest.
Yields on bonds and guaranteed investment certificates (GICs) have skyrocketed on the back of a nearly five per cent increase in interest rates in less than two years, but the average Canadian “fixed income” fund has actually lost money – down 1.7 per cent so far this year and a jaw-dropping 11.5 per cent in 2022.
THERE’S NOTHING FIXED ABOUT FIXED-INCOME FUNDS
Bonds and GICs are considered fixed income because they have a set yield and a set maturity date. Investors know the exact amount they will receive at that time. Being able to rely on the cash they generate is essential for those near, or in retirement who need to draw on it for living expenses.
Bond funds, on the other hand, can not provide that certainty because they invest in a portfolio of fixed-income securities that are often traded on the broad bond market several times before maturity.
In a rising interest rate environment, the yield on bonds at any given time is higher than it was in the past but lower than it will be in the future, which lowers its present value on the bond market.
“The average interest rate on the bonds in their portfolios has been rising but the bond prices are declining because interest rates have been rising. Bond prices are inversely correlated with interest rate changes,” says David O’Leary, founder of Toronto-based Kindwealth.
“If I own a 30-year bond paying three per cent interest and interest rates go up to three per cent, no one will want to buy that bond from me unless I lower the price because they can just buy a new 30-year bond paying five per cent,” he says.
“On the flip side, if interest rates go down, my existing bond will be worth more because the new bonds being issued are only paying, say, 2 per cent. So, they will pay me a higher price for my 3 per cent bond” he adds.
WHY THE FINANCE INDUSTRY PUSHES BONDS AS FIXED INCOME
Any properly diversified retirement investment portfolio will have a fixed income component as a stabilizer against volatility on the equity side of the portfolio. The exact portion depends on the risk tolerance and time horizon of the individual investor.
Investment advisors will often substitute the fixed income portion with a bond fund for a couple reasons. In many cases, the advisor is only qualified to sell mutual funds or is not able to directly access bonds.
Bond funds also provide big commissions for the advisor. Annual fees on bond funds (known as the management expense ratio or MER) can be as high as 2.4 per cent of the amount invested. Baked into that fee is a hidden trailing commission of about one per cent that the mutual fund company gives to the advisor.
That means a bond fund with a 2.4 per cent annual fee will need to generate a return of 7.4 per cent to give the investor a five per cent return.
In contrast, advisors who access bonds directly are normally not compensated by the investor.
WHAT IS FIXED INCOME, REALLY?
GICs, government or investment-grade corporate bonds held to maturity are fixed income because their returns are fixed and reliable.
Their biggest downside is their lack of liquidity because the investor must wait until they mature to access the cash.
However, there are strategies that can be employed to increase liquidity in a fixed-income portfolio such as “laddering,” where maturities are staggered over several time periods.
In addition to providing more paydays, laddering can also provide more opportunities to get the best going yields at that time.
Yields on bonds and guaranteed investment certificates (GICs) have skyrocketed on the back of a nearly five per cent increase in interest rates in less than two years, but the average Canadian “fixed income” fund has actually lost money – down 1.7 per cent so far this year and a jaw-dropping 11.5 per cent in 2022.
THERE’S NOTHING FIXED ABOUT FIXED-INCOME FUNDS
Bonds and GICs are considered fixed income because they have a set yield and a set maturity date. Investors know the exact amount they will receive at that time. Being able to rely on the cash they generate is essential for those near, or in retirement who need to draw on it for living expenses.
Bond funds, on the other hand, can not provide that certainty because they invest in a portfolio of fixed-income securities that are often traded on the broad bond market several times before maturity.
In a rising interest rate environment, the yield on bonds at any given time is higher than it was in the past but lower than it will be in the future, which lowers its present value on the bond market.
“The average interest rate on the bonds in their portfolios has been rising but the bond prices are declining because interest rates have been rising. Bond prices are inversely correlated with interest rate changes,” says David O’Leary, founder of Toronto-based Kindwealth.
“If I own a 30-year bond paying three per cent interest and interest rates go up to three per cent, no one will want to buy that bond from me unless I lower the price because they can just buy a new 30-year bond paying five per cent,” he says.
“On the flip side, if interest rates go down, my existing bond will be worth more because the new bonds being issued are only paying, say, 2 per cent. So, they will pay me a higher price for my 3 per cent bond” he adds.
WHY THE FINANCE INDUSTRY PUSHES BONDS AS FIXED INCOME
Any properly diversified retirement investment portfolio will have a fixed income component as a stabilizer against volatility on the equity side of the portfolio. The exact portion depends on the risk tolerance and time horizon of the individual investor.
Investment advisors will often substitute the fixed income portion with a bond fund for a couple reasons. In many cases, the advisor is only qualified to sell mutual funds or is not able to directly access bonds.
Bond funds also provide big commissions for the advisor. Annual fees on bond funds (known as the management expense ratio or MER) can be as high as 2.4 per cent of the amount invested. Baked into that fee is a hidden trailing commission of about one per cent that the mutual fund company gives to the advisor.
That means a bond fund with a 2.4 per cent annual fee will need to generate a return of 7.4 per cent to give the investor a five per cent return.
In contrast, advisors who access bonds directly are normally not compensated by the investor.
WHAT IS FIXED INCOME, REALLY?
GICs, government or investment-grade corporate bonds held to maturity are fixed income because their returns are fixed and reliable.
Their biggest downside is their lack of liquidity because the investor must wait until they mature to access the cash.
However, there are strategies that can be employed to increase liquidity in a fixed-income portfolio such as “laddering,” where maturities are staggered over several time periods.
In addition to providing more paydays, laddering can also provide more opportunities to get the best going yields at that time.
