[January 2007]

With income trusts losing some steam since the Canadian government announced impending tax changes, staid and steady bonds have inched up on the scale of relative attractiveness for income-hungry investors. The return offered by bonds is still relatively skimpy in today’s low-interest environment, but bonds offer a predictability of income superior to the dividends paid by equity investments.

“Bonds are about avoiding losses and stabilizing an investment portfolio,” says Adrian Mastracci, president of Vancouver-based KCM Wealth Management Inc. and a private-client portfolio manager. “They have a return you can count on, and they can cushion the fall when things go haywire on the equity side. The capital preservation offered by bonds has a lot going for it, and even aggressive investors should have some protection in their portfolios.”

With five- and 10-year Canadian government bonds offering yields of slightly less than 4%, the return is not particularly exciting. In addition, interest income paid by bonds is fully taxable. If market interest rates rise in the future, bonds issued at today’s relatively lower interest rates will fall in price compared with future issues with more generous coupons. Holders of today’s bonds could be faced with capital losses if they sell in the market rather than holding to maturity. However, as long as your clients don’t sell before maturity, they will know exactly what the return will be on their bonds, and financial planning can be done accordingly.

With many signs pointing toward a slowdown in the North American economy, it’s unlikely the Bank of Canada or the U.S. Federal Reserve Board will jack up interest rates soon, which means this could be an opportune time for your clients to acquire some bond holdings. However, the economic signals are mixed. Employment, consumer confidence and retail sales are still perking along in Canada and the U.S., and the economic slowdown and accompanying drop in interest rates may not materialize as quickly as some economists anticipate.

“We think rates are on hold for at least the next quarter or two, and there’s a better chance of a rate cut in mid-2007 than a rate hike,” says Tristan Sones, vice president and portfolio manager at Toronto-based AGF Funds Inc. “The U.S. housing market has slowed, and while the consumer has so far been holding on, a slowdown in the housing market is typically followed by reduced consumer spending within a couple of quarters. We’re also seeing some cracks in the economic armour in Canada. Bonds tend to do well when the economy slows and interest rates fall.”

There are various types of bonds, including provincial and federal government bonds, real-return bonds, corporate bonds and foreign bonds. Buying individual bonds can make a lot of sense when your client wants to hold to maturity, but a bond mutual fund or exchange-traded fund offers greater diversification across lengths of terms and types of bonds.

Some analysts do not recommend bond funds for clients who want to keep exclusively to safe Government of Canada bonds. Fund management fees eat away at returns, and professional management and diversification isn’t as valuable with such safe securities. However, even a fund that invests predominantly in Canadian government bonds can be worthwhile if its fees are low and it can capitalize on interest rate moves by moving between short- and long-term bonds at the right time.

Beutel Goodman Long-Term Bond Fund, sponsored by Toronto-based Beutel Goodman Managed Funds Inc. , is a top-quartile performer with a low MER of 0.63%. Another low-fee, good performer is PH&N Total Return Bond Fund Series A, offered by Phillips Hager & North Investment Management Ltd. of Vancouver.

“With government bonds, there’s not much benefit to paying the fees of a bond fund manager as there is no credit risk,” says Dan Hallett, president of Windsor-based fund analyst Dan Hallett & Associates Inc. “An investor is better off picking a bond that matches his or her time frame and holding it to maturity, when the principal will be fully repaid. Remember that a bond fund continually turns its portfolio over, unit values can fluctuate and it does not mature at face value on a given date as an individual bond does.”

Investors seeking maximum returns in bonds will want to move up the risk ladder, adding high-yield corporate bonds and global bonds to their portfolios. And that’s when a diversified portfolio and professional management are more valuable.

@page_break@With corporate bonds and those issued by less established governments, there is the possibility of default on interest payments, or even loss of principal if the issuer goes bankrupt. Because of the higher risk, these securities have higher yields than government bonds issued by established countries. The yield differential depends on the bond’s quality, with top-rated blue-chip corporates offering a yield advantage of less than half a percentage point relative to a comparable Canadian government bond, while those rated below investment grade could have a yield advantage of three to five percentage points and sometimes more. GGOF High Yield Bond Fund, sponsored by Toronto-based GGOF Guardian Group of Funds Ltd. , for example, has an average yield on its portfolio of close to 8%, roughly double the current yield of a Canadian government bond.

“Diversification is more important with corporate bonds as you want to avoid companies that might go bankrupt and find those that could get upgrades in their credit ratings and hence a better price on their bonds,” says Stephen Kearns, managing director of fixed- income investments at Toronto-based Guardian Capital LP. “A fund can spread the risk across 30 to 50 issues, and that’s difficult for a retail investor to do.”

The analysis of corporate bonds is akin to the process involved in examining potential equity purchases. Fund managers examine factors such as a company’s cash-flow growth and balance-sheet strength. Corporate bonds tend to be much more sensitive to factors affecting the business of the individual company than to the general direction of interest rates.

“We look at corporates on a case-by-case basis,” says Tom Nakamura, associate fixed-income portfolio manager at AGF. “The bottom-up fundamentals of a company are important. We analyse its prospects in the near and medium term, then take a hard look at price to make sure we are being compensated for the risks and rewards of that specific company.”

When choosing a bond fund, it’s important to take a close look at management expenses, as they can take a big bite out of the already paltry returns. According to Toronto-based Morningstar Canada, the average MER for Canadian core fixed-income mutual funds is 1.35%, which is relatively high for the average annual compounded return of 4.8% offered by such funds for past three years.

A less expensive alternative is an exchange-traded bond fund offering a diversified portfolio based on a bond index. For example, Barclays Global Investors Canada Ltd. of Toronto offers six closed-end bond funds that trade on the Toronto Stock Exchange, including an iShares Canadian bond index fund, a long bond index fund, a short bond index fund, a government bond index fund, a corporate bond index fund and a real-return bond index fund. MERs range from 30 to 40 basis points, although ETF returns will be eroded by any commissions charged when units are bought and sold by clients.

There is also an opportunity to pick up additional yield by going global. Interest in global bonds has picked up since the foreign-content restriction was removed from RRSPs, and investment in foreign bonds has roughly doubled in each of the past two years, according to Statistics Canada.

As an example of yield differentials among government bonds, while a five-year Canadian bond currently has a yield of 3.8%, comparable U.S. bonds are offering 4.4%, British bonds offer 4.8% and Australian bonds yield 5.84%.

Foreign bonds carry the additional risk that currency movements could have a negative impact on returns, however, And although some bond fund managers employ currency hedging strategies, the costs could eat up some of the return advantages of international diversification.

“Global economies and interest rate cycles are not perfectly synchronized around the world, and bond market opportunities can be found in different places at different times,” says Elizabeth Lunney, senior vice president at Toronto-based Fiduciary Trust Co. of Canada, a division of Toronto-based Franklin Templeton Investments Corp. “There are also opportunities to access higher rates outside the country.”

Michael Hart, head bond trader at Friedberg Mercantile Group Ltd. , which sponsors Friedberg Foreign Bond Fund, the top-performing foreign bond fund for the past three years with an 8.1% average annual return at Oct. 31, has found opportunities lately in euro-denominated real-return bonds.

“Buying bonds is like being a wine connoisseur,” Hart says. “If you restrict yourself to the domestic market, in which some of the wines are indeed very good, you’re missing opportunities in places such as France, Germany and Chile. Why cut yourself off from great foreign opportunities?”

Although inflation has been relatively benign lately, hovering around 2% annually for the past decade, it can be what Hart calls “an insidious culprit” for bonds. Inflation usually portends higher interest rates and declining purchasing power of currencies, which erodes the purchasing power of the interest coupons on bonds as well as their ultimate redemption values. One way to protect clients against inflation is through purchasing real-return bonds, either individually or through a mutual fund or ETF specializing in this category. The Canadian federal government and various provinces issue real-return bonds for which both the semi-annual interest payment and the value received at maturity increase in line with the consumer price index.

As with other bonds, the interest paid by real-return bonds is taxed as ordinary income. However, with real-return bonds, the disadvantage is that adjustments in face value resulting from inflation are also taxed as income, and the taxes must be paid annually even though the holder doesn’t actually capitalize on those gains until the bond is sold or it matures. If the bonds are held in an RRSP or other tax-sheltered account, these annual income taxes can be deferred. ie



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