In most investing literature, the fixed income component of a portfolio is assumed to take the form of bonds. For accounts that do not possess a sufficient net worth (for example more than $500,000), it is usually difficult to sufficiently diversify across various issuers of bonds, so many investors have turned bond funds for convenience. However, all bond funds have management fees, which, in this low-yield environment, are likely to eat up a significant chunk of your returns. Read on for details...
A Few Key Terms
When looking at a bond mutual fund or a bond ETF, there are several factors that affect the performance of the fund going forward. These are usually found in a fund "fact sheet" and are updated monthly or quarterly. In the case of ETFs, the website of the ETF provider usually updates these values daily. The following are some of the more critical factors:
- MER: the management expense ratio, or annual fee, that the fund charges
- Bond rating: usually given as percentages of which bond the fund owns that are AAA (highest-rated), AA, A, BBB (generally the lowest rating still considered investment-grade), and less than BBB (commonly called "junk bonds")
- Duration (years): the sensitivity of the fund to changes in interest rates. A bond fund with a duration of 6 years will go up (or down) by approximately 6% if interest rates drop (or go up) by 1% across all maturities.
- Weighted average maturity (WAM): the weighted average time to maturity of the bond fund, weighted by the size of the bonds owned by the fund
- Yield to maturity (YTM, %): the % annual return (before trading fees and management expenses) that can be expected if the interest rates stay constant through the weighted average maturity of the fund
A Sample Actively Managed Bond Fund
To illustrate what these numbers look like for a typical actively managed bond fund, we will use the RBC Bond Fund. According to the fund fact sheet, the Series A MER of this fund is 1.22%. The fund holds mostly AA-rated investment-grade bonds. The duration is 7.5 years, the WAM is 10.3 years, and the YTM is 2.3%.
To interpret these values, if interest rates stay constant, you can expect a return of about 1.1% per year after management fees (2.3% - 1.22%) through the 10.3 years WAM. However, if interest rates fell (rose) across all maturities by 1%, you would see a price increase (decrease) on the fund of approximately 7.5%. About two months ago the Bank of Canada reduced interest rates by 0.25%, so the RBC Bond Fund would have experienced a price increase of about 2%.
However, unfortunately, when interest rates start going up, every 1% increase in interest rates across maturities will cause a price decrease to the fund of approximately 7.5%! As a result you could lose money on this investment, even though it purchased relatively high credit rating bond issues.
A Sample ETF
An ETF that is similar to the RBC Bond Fund is the Vanguard Canadian Aggregate Bond Index ETF. According to the fund fact sheet, the MER is 0.12% (compare this to the 1.22% of the actively managed bond fund!), and the fund has mostly AAA and AA rated bonds (slightly higher quality, on average, than the RBC Bond Fund). The fund has a duration of 7.9 years, a WAM of 11 years, and a YTM of 1.61%.
If you hold this fund for the WAM, and interest rates stay constant through this period, your expected return is about 1.5% per year (1.61% - 0.12%). Compared to the actively managed bond fund, this would result in an increased return of approximately 0.4% (1.5% - 1.1%) through the WAM of approximately 10 years. Interest rate increases or decreases would affect the price of this ETF in a similar manner to the actively manged bond fund.
Guaranteed Investment Certificates
Guaranteed Investment Certificates (GICs), are issued by a financial institution and are guaranteed to pay a fixed interest rate for a fixed number of years. The Canadian Deposit Insurance Corporation (CDIC) is a Crown Corporation which guarantees the funds held in a GIC in case the issuing financial institution becomes insolvent (to a maximum of $100,000 per institution). Consequently, if an investor purchases a GIC within the limits of the CDIC coverage, there is no default risk in a GIC.
Five-year GICs are available at many banks with rates of approximately 1.5%. To compare more directly with the above bond funds (which had WAMs in the 10 - 11 year range), a 7-year GIC from RBC is currently available at 1.85% per year. Assuming that you do not require your investment funds back for at least 7 years, it would not make sense to purchase either of the bond funds discussed above, and a GIC would be the preferred investment.
Feel free to contact us if you have any questions about the hundreds of fixed-income products available. Also, don't forget, you should put any the aforementioned funds or GICs in a TFSA or RRSP!
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