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Why Bond Funds May Still Make Sense

When managed sensibly, bond funds can help your portfolio in ways that other investments cannot.

How bond funds fit

Bonds are the "Steady Eddies" of the investment world. They deliver regular income with little fanfare. While equities grab the headlines, bonds are hardly noticed, that is until markets get rocky. Then, their ability to play defense and preserve capital captures all the attention.

Investment in bond focussed mutual funds has long been favoured by investors seeking steady cash flow at low risk or a safe haven from economic weakness and recession. Because bond prices move in the opposite direction of interest rates, the extended period of falling rates we've experienced means long-time bond investors have done exceptionally well. From 1981 when interest rates peaked in North America through 2011, the Ibbotson Long-Term Government Bond Index in the U.S. outperformed the S&P 500 Total Return Index over a 30-year period for the first time since the Civil War.

Bond fund performance

While they can't often match the upside potential of equities, investing in bond funds comes with far more predictability. Research from Vanguard Investment Strategy Group found that from 1998 to 2011, a period capturing both bull and bear markets in the U.S., bonds, represented by the Barclays Capital US Aggregate Bond Index, generated an average annualized return comparable to dividend-paying stocks in the S&P 500 Dividend Aristocrats Index, but with far less variance year-to-year (a standard deviation of only 3.6% in returns, versus 15.3% for stocks). This reliability has been evident in our own bond market. The DEX Universe Bond Index has seen only two losing years in the last two decades, the worst being a modest 4.3% loss in 1994.

What's different about bond funds is they tend to have a weak or negative correlation with growth-oriented mutual funds that include stocks or real estate, making them a valuable counterweight in an investment portfolio. During the financial crisis when most investments dropped significantly in value, quality bond funds held their ground.

Finding the right balance

While the last three decades have been a golden age for investment in bond mutual funds, odds are this level of performance is mostly behind us. Interest rates have already fallen significantly bringing down yields to unappealing levels and leaving little room for further capital gains. When rates do eventually move higher bond fund values will be at risk.

Just how much bond fund exposure should you have? As with other asset categories you hold like equity based mutual funds and cash, how much of your portfolio you want represented by bond funds will depend on your investment time frame, risk tolerance and objectives.

As you get older you're more likely to seek out regular income from a stable investment so bond funds are a natural choice. But relying too heavily on bond funds can be a mistake even as you age. With more retirees living into their 80s, 90s and beyond, nest eggs will need to last longer than in the past. Continuing to hold growth-oriented investments in your later years can be a key strategy to protecting your income and capital from inflation over time.

Once your ideal fixed income allocation is set, regular rebalancing will ensure your investment portfolio remains properly diversified.

Duration: predicting what happens when rates move

Duration helps you estimate how much the value of a bond will change in response to a 1% move in interest rates. For example, say rates rise 1%. A bond portfolio with an average duration of five years would be expected to lose about 5% of its value. A bond fund with a duration of ten years would likely see a 10% price drop. The longer the duration of a bond fund, the more sensitive it is to interest rate changes, up or down. So if you're nervous about rates going up lean toward shorter-term bond funds which will be less affected.

Charging up your income portfolio

Before low yields have you exiting bond funds, here are five ways to boost the performance of your income investments.

1. Add corporate bond mutual funds. As with equities-based mutual funds, not all bond funds are identical. Generally, government bond funds have the lowest risk, but that safety comes at a price: potentially low returns.

One way to perk up your portfolio is by adding corporate bond funds. If you invest in a broadly-based bond mutual fund it will likely hold some corporate bonds. Because they're riskier than government issues, corporate bonds offer higher return potential. With high-quality, "investment-grade" bonds from established enterprises like the big banks or the major telecoms and utilities, that additional risk is minimal.

2. Look at the high-yield market – carefully. If you're comfortable reaching out further on the risk spectrum, investing in high-yield bond funds with still-higher return potential is an option. High yield bond funds hold bonds issued by companies that lack the credit worthiness to earn investment-grade status, these bond funds offer better yields to compensate investors for the higher risk involved. High-yield bond fund returns become tied to uncertainty around company fortunes as much as to interest rates. Consequently, these funds wind up acting more like equity funds when there's market turmoil, making them poor diversifiers of capital risk.

3. Consider real return bond mutual funds. The values of bond investments and their interest payments are generally at risk to inflation, but real return bond funds are an exception. These specialized bond funds protect investors by linking bond principal and interest to the consumer price index. If inflation eventually roars back, real return bond funds can keep pace even as the purchasing power of traditional bonds erodes.

4. Use tax shelters. Bond interest is taxed at the highest marginal rate, so holding bond investments in a tax shelter like an RRSP or TFSA can help you keep more of those earnings. Should rates fall further any capital gains created will also be sheltered.

5. Diversify into dividend focussed mutual funds. The plunge in bond rates has left the dividend yield of the S&P/TSX Composite Index comfortably above the yield on the benchmark 10-year Government of Canada bond – a rare event.

Mutual funds that focus on dividend-paying stocks, including preferred shares and REITs, have become important income options to charge up your cash flow.

Unlike bond payments which are fixed, dividends can be raised regularly, helping hedge your income against inflation. Corporate balance sheets and earnings continue to be resilient leaving companies in a healthy position to hike their payouts. In 2012, dividend increases by S&P 500 companies totalled 333, up 4% from a year earlier. Factor in tax-savings through the Dividend Tax Credit and diversifying your income to include dividend paying mutual funds can be a smart play in today's low interest rate environment.

Why dividend-paying mutual funds can't replace bonds funds

Despite their attraction as an income alternative, choosing mutual funds focussed on dividend-paying holdings doesn't mean you should forget about bond funds entirely. The risk profile of dividend funds closely resembles the broader equity market, not bond funds. One example…during last May's turbulent markets when the S&P/TSX Capped Composite Index fell 6.1%, the Dow Jones Canada Select Dividend Index, a collection of leading dividend-payers was down a comparable 5.8%. Meanwhile, the DEX Universe Bond Index went in the opposite direction jumping over 2%. The lesson is that dividend-paying mutual funds may be a good choice to help you generate income, but don't expect them to do much to reduce volatility in your portfolio.

The bottom line

After years of declining interest rates it's unlikely that bond funds will continue to generate above-average returns going forward. But that doesn't mean they're no longer valuable.

No matter where interest rates are, bond funds can still play an essential role in providing regular income while helping steady a portfolio, especially when uncertainty strikes financial markets. But with capital gains less likely and interest rates possibly remaining low, it's important to set realistic expectations for what your bond portfolio can do. Through our partnership with Credential®, your BlueShore Financial advisor can help you get the most out of your bond asset class and explore options to take your income further. Contact your financial advisor to learn more.

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Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Unless otherwise stated, mutual fund securities and cash balances are not insured nor guaranteed, their values change frequently and past performance may not be repeated.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Unless otherwise stated, mutual fund securities and cash balances are not insured nor guaranteed, their values change frequently and past performance may not be repeated.

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