When you think about investing for retirement, you have to worry about the primary goals of safety of capital and, of course, keeping up with inflation. In the 12 months ended Sept. 30, meeting those two goals has been challenging, to say the least. But while stocks have languished through the recession, bonds have performed remarkably well.

Canadian fixed-income portfolios rose by an average of 8.9% while Canadian equities portfolios fell by 0.6% in those aforementioned 12 months.

These one-year returns for bonds are not typical, as stocks have beaten the returns of bonds over the long term. But bonds represent safety: they are contractual promises to pay interest and to repay principal lent to the borrower.

Entities such as provinces and the U.S. and Canadian federal governments do not default. In addition, corporate bondholders can enforce their rights and seize assets of deadbeat companies if they are not paid. Stockholders get only the leftovers after costs, including interest paid to bondholders, have been paid.

Yet, over long periods, the returns on taking chances on stocks has usually beaten the returns of taking less risky chances on bonds.

Those risks hammer stocks in downturns. Stocks can lose half their value, as they did in the collapse in the S&P/TSX composite index’s value from its historical high in June 2008 to its gut-wrenching bottom this past March. But investment-grade bonds tend to hold their value in good times and bad.

What’s more, RRSPs are the ideal place to hold bonds. In non-registered accounts, interest is taxable. Given that interest income is very low these days, giving half away to the government is not attractive. However, when interest is earned within RRSPs, it is preserved until it is paid out. It can compound for years unmolested by taxes, and more of it can be retained if you’re in a lower income bracket in retirement.

So, given the benefits of holding bonds in RRSPs, should you recommend bond mutual funds, bond exchange-traded funds or actual bonds to your clients?

Says Adrian Mastracci, a portfolio manager and president of KCM Wealth Management Inc. in Vancouver: “I try to avoid bond mutual funds because they always remain invested and never turn back into money. If your bond fund runs negative returns — which can and does happen when interest rates rise and old, relatively low-interest bonds wind up being traded at discount prices — a bond fund will generate red ink. But a real bond will come out whole, with no loss when it matures.”

Bond mutual funds do not have automatic cash reversion; all they do is reflect the changing prices of the bonds and cash they hold. You can sell, but you remain at the whims of the market until you do.

Still, bond mutual funds that are managed well have produced terrific returns this past year, beating the performances of bond indices and the ETFs that replicate them. The DEX all-corporates bond index, which tracks Canadian issues, gained 15% in the nine months ended Sept. 30. But some able managers have beaten the averages. For example, Chris Horoyski, senior vice president for fixed-income with Aurion Capital Management Inc. in Toronto, produced a 26% return in her bond portfolios over the same period as a result of judicious trades.

Most of the time, however, bond mutual funds lag indices because the funds charge high management fees, which average 1.6% of net asset value. The median fund, BMO Bond Fund, sponsored by BMO Investments Inc., sports a fairly representative 4.7% average annual compound return for the 10 years ended Sept. 30. But paying a management expense ratio of 1.56% to get that return, Mastracci says, is a high price.

There is a compromise available in laddered bond ETFs. In these low-fee portfolios that hold bonds with staggered terms, there are always some bonds maturing and turning back into cash. For example, Claymore 1-5 Year Laddered Government Bond ETF produced a 6% return for the 12 months ended Sept. 30. This ETF has a very low MER of 0.15%. There is no active management and, in most years, low-cost bond ETFs beat the returns of managed bond funds because of the latter’s high fees.

Government bonds are safe. However, if interest rates were to spike to double-digit levels, as they did in the early 1980s, then government bonds would be badly hurt. Existing bonds with relatively low coupons would have to drop in price until their yield equals that of new, higher-interest bonds.

@page_break@To avoid that kind of loss, you can recommend real-return bonds to your clients. These RRBs adjust their value to match increases in the consumer price index. The increased price of the bond will be paid to the holder at maturity. In the meantime, investors are taxed on the rising price of the principal value of the bond in non-registered accounts.

“RRBs in taxable accounts take it on the chin,” Mastracci says. “They have to pay taxes on both the interest they get and the rising value of the bond, which they don’t even get if they hold it for a few decades.”

But in RRSPs, the returns of RRBs are sheltered from taxes. As such, this is the only place your clients should hold these complex bonds.

RRBs can be purchased directly or through mutual funds, such as TD Real Return Bond Fund, with its 1.42% MER; it generated an 8.9% return for the 12 months ended Sept. 30. Meanwhile, Barclays iShares Canadian Real Return Bond Index ETF, which has a 0.35% MER, produced an 8.7% return for the period. Although the TD fund beat the index, its high MER drastically narrowed the gap.

Another benefit of inflation-indexed bonds is that they will not suffer when interest rates rise, as rates will when the bust gives way to the next boom. Conventional bonds, especially those with 10 or more years to maturity, could show some paper losses before they mature.

Still, as Dan Stronach, head of Stronach Financial Group in Toronto, notes: “Bonds have a lot to offer. They are your [clients’] stabilizer. They will save [clients’] portfolios from a lot of volatility.” IE