If you are looking to provide your clients with a bond fund but want much more control and lower management fees than bond mutual funds provide, you should consider bond exchange-traded funds. In addition to the above benefits, bond ETFs also make it possible to tailor term, income and even interest-rate sensitivity to the client’s needs.

Essentially, bond ETFs are portfolios of bonds with defined characteristics, such as country of issue, government or corporate, or average term. They are an important innovation; until now, a financial advisor could either advise purchase of bonds at what were usually very high margins charged by investment dealers or pick bond mutual funds on the basis of past performance, fees or fund family.

Perhaps the most important characteristic of bond ETFs is their fee efficiency. “If you compare bond ETFs to bond funds as a group, the main difference is in the fees,” says Dan Hallett, president of mutual fund research firm Dan Hallett & Associates Inc. in Windsor, Ont. “And that makes a world of difference in return and the ability to trade efficiently.”

For instance, the management expense ratio on traditional Canadian bond funds averaged 1.99% for the year ended of Dec. 31, 2005. Considering that Canada bond funds produced an average annual return of 5.1% in that time period, the MER is astonishing.

ETFs, on the other hand, charge a lot less. Barclay’s Global Investors Canada Ltd. , the largest ETF manager in Canada, operates iUnits Canadian Bond Broad Market Index — which trades as XBB on the Toronto Stock Exchange. Designed to emulate the broadest bond index in Canada — the SC universe bond total return index — XBB has a management fee of 30 basis points, which works out to 15% of the usual 1.99% bond mutual fund MER. XBB has an average term to maturity of almost 10 years, a weighted average yield of 4.25% and a known duration (sensitivity to interest rate changes) such that for every 1% rise in interest rates, XBB will decline in market price by 6.48% — or rise by that amount if interest rates decline by 1%. XBB has recently traded at $29 per share; a round lot of 100 shares is $2,900 plus commission.

There are other bond ETFs with more focused content. Barclay’s iUnits Short Bond Fund (TSX: XSB) has bonds with maturities of one to five years, a 0.25% MER, an average term of maturity of 3.04 years, a 4.02% average yield; for every 1% change in interest rates, XSB will move by 2.67% in the opposite direction.

Bond ETFs make it possible to trade in a way that is almost impossible with bond mutual funds. Bond mutual funds are priced at the end of the business day: that value is either the entry or the exit price. ETFs trade like stocks, which means they can be traded at any moment of the day in which stock exchanges are open. They can be bought and sold with limit orders set to the most a client will pay to buy, or set to the lowest point at which the client will sell. ETFs can also be traded with stop-loss orders.

In addition, the low ETF trading costs allow advisors and clients to be efficient traders. For example, a major investment dealer offers a 4.3% Manitoba provincial bond due March 1, 2016, at $102.18 per bond at the time of writing. Bonds are customarily priced in hundreds, even though traders really deal in $1,000 units. So this deal would cost $102,180 for $100,000 worth of the bonds. If an investor decided to sell the bond back to the dealer at a later time, he or she would get $100,030. So the spread is $2,150, or 2.1% of what the investor would have paid on the buy side when he or she got into the bond. And that may wipe out the potential profit on the deal.

The trade works much better with an ETF. The Manitoba bond will be part of the 62% of government bonds that make up XBB. A round trip on a trade of $100,000 for 3,400 shares of XBB, which costs $98,600, could have commissions of perhaps $14 to $60, depending on the broker used to do the trades. A $60 fee on the $98,600 deal could be covered with a move of less than 2¢ in XBB’s price.

@page_break@This should not be interpreted to mean that one should day-trade bond ETFs, but it does show the fee efficiency of the process in capturing small price moves.

To see how bond ETFs can be tailored to a client’s needs, consider Client A. At 55 years of age, the client plans to retire in 10 years. He has $1 million in financial assets, of which $550,000 is in resources equities. The remaining $450,000 can be converted to cash without fees or taxes. The client’s resources funds gave him a superb return last year, with an average gain of 43%. However, the advisor fears that a tumble in resources stocks and a potential recession will crush the value of the portfolio.

A solution here would be to buy XBB. Assume that the world economy goes into a tailspin and that, as a result, resources stocks lose 20% next year, reducing the value of the $550,000 stock portfolio by $110,000. If the Bank of Canada, in seeking to revive the economy, were to drop interest rates by 3.5%, then the $450,000 investment in XBB would rise in market price by 22.68%, since each interest rate percentage drop would increase the price by 6.48%. In the end, this would produce $102,060, offsetting most of the stock loss. XBB’s 4.25% yield would make up the difference of $7,940 if it were held for most of a two-year period.

Client B, who has $2 million in financial assets, plans to send her 16-year-old daughter to study in the U.S. in a year, where she won early admission to an elite university. But now the client must cover the cost of a four-year degree in which her daughter’s tuition, board and room would total US$50,000 annually.

The client’s advisor thinks that within two years, the Canadian dollar will peak in relation to the U.S. dollar, then decline. So a solution would be to buy US$200,000 of iShares Lehman Two- to Three-Year Treasury Bond Fund, which trades as SHY on the American Stock Exchange. This bond ETF has produced an annual return of 5.77% in US$ since its inception in July 2002. And in using this bond, the U.S. currency exposure is covered.

In addition, an inflation-linked ETF — such as the iShares Lehman TIPS Bond, which also trades on the AMEX — could also be used as it would pace changes in the U.S. consumer price index. Its 0.20% MER also makes it an efficient tracker.

Even though bond ETFs provide trading precision as well as low management and trading costs, they are not right for every application. Trading in and out of ETFs will generate sales costs and, for non-registered accounts, may produce tax liabilities. ETF income distributions must be collected and used to buy more ETF units because there is no automatic reinvestment process at present.

Conversely, all mutual funds provide for reinvestment as well as free or low-cost switches. Some funds, structured into Corporate Class shares, can provide switches with no tax consequences for non-registered accounts. IE