Given the outlook for see-sawing interest rates this year, bond investors have their work cut out for them.

Rates are set to rise, then decline by mid- or late 2006. A period of rising rates calls for a defensive stance, with a bias toward short-term bonds. The following period of declining rates calls for an aggressive stance, with bonds with longer maturities or long strips structured to produce the greatest gains. For bond investors, the challenge is to play the trend of rising and then falling rates. There are strategies and instruments to deal with these expectations, each with distinct advantages and disadvantages, interest rate sensitivity and trading costs. Here are a few of them:

> Direct purchase of bonds that pay coupons and revert to cash at fixed dates. A bond portfolio can be tailored to term with selected coupons and interest rate sensitivity.

Buying individual bonds allows the investor the greatest flexibility in setting maturity dates. If held to maturity and if the issuer pays up on time (default is not a risk for government bonds but is a potential risk for corporate bonds), fluctuations in market value will disappear and the bond will expire at its designated value at term. The bondholder will get the real deal — cash, which is something bond funds, which merely carry forward gains and losses, never provide.

On the downside, investors who buy individual bonds must pay the high fees levied by investment dealers — charged as spreads between wholesale costs paid by dealers and retail prices charged to retail clients. However, investors who buy and hold to maturity need only pay their spreads once.

> Laddered bonds. A ladder of individual bonds uses cash reversion to reduce the downside risk that any one bond carries when rates rise. If rates rise, matured bonds in the ladder can be rolled into new bonds at higher interest rates. If rates fall, the ladder captures some of the increased value of the coupons. Ladders can be constructed with bonds that provide cash for milestone events in life, such as children going through university or a major vacation. Ladders inevitably average out rate expectations.

> Bond mutual funds. Bond mutual funds offer professional portfolio management; coupon reinvestment; accounting for gains, losses and distributions; and opportunities to switch in and out of fund families at low or zero cost.

But the service bears a price. Dan Hallett, president of Dan Hallett & Associates Inc. , a mutual fund research firm in Windsor, Ont., notes that the median MER for conventional bond funds is 1.6% a year.

Fees show up in bond fund returns. For example, for the 10 years ended Nov. 30, 2005, Canadian bond funds had a mean compound average annual return of 6.2%. The SC universe bond total return index — the definitive benchmark for Canadian bonds — produced a 7.7% average annual compound return in the same period. Bond fund management fees therefore tend to dull the gains that can be achieved with optimal selection of bonds for anticipated interest rate changes.

> Bond exchange-traded funds. Bond exchange-traded funds tend to beat bond mutual funds. In a sector of highly constrained returns, leading ETFs such as the iUnits portfolio that replicates the Scotia Capital short-term bond index and the iUnits Canadian Bond Broad Market Index Fund charge 25 basis points for management each year.

On top of the fees, there is an embedded cost of three bps for trading expenses, according to Barclays Global Investors Canada Ltd. , the Toronto-based company that runs the iUnits portfolios. The total MER of the funds is 28 bps. That is only 17.5% of the median bond mutual fund MER. Lower ETF expenses make a huge difference in returns.

Howard Atkinson, head of business development for Barclays, notes: “If you rank the iUnits with three-year performance records by quartile, you find that virtually all are in the first quartile of performance compared with mutual funds in the same asset classes and sectors.”

Clearly, efficiency pays.

But there are other differences. Michael Crofts, portfolio manager of Calgary-based Mawer Investment Management Ltd. ’s Canadian Bond Fund, says mutual fund managers tend to take less risk than is built into the SC universe bond total return index, the sector’s benchmark. “Conservatism drives managers to have bonds a little less sensitive to interest rate changes than the average of bonds in the index. There are liquidity issues, too, that prevent fund managers from buying all the bonds in the index.”

@page_break@Crofts’ own fund, which has a below-average MER of just 1.1%, beat the bond-sector average for periods of one to 10 years ended Oct. 31, 2005, and for eight of the 10 calendar years between 1995 and 2004. But the fund did not beat the SC universe bond total return index for any single calendar year nor for one, two, five nor 10 years on a compounded basis. Playing safe means holding bonds with generally shorter durations than the index and that, in turn, leads to lower returns over the long run.

ETFs provide potential diversification for investors that is more country- or type-specific than most mutual funds can offer. For example, Barclays iShares, the trade name of its U.S.-based ETFs, include American Stock Exchange-traded assets:

> Lehman 1- to 3-Year Treasury Bond Portfolio;

> Lehman 7- to 10-Year Treasury Bond Fund;

> Lehman Aggregate Bond Fund;

> Lehman 20+ Year Treasury Bond Fund.

Investors can also buy European ETF portfolios, including the following, which are traded on the London Stock Exchange:

> iShares £ Corporate Bond ETF;

> Euro-denominated Corporate Bond ETF;

> iShares Euro-denominated Corporate Inflation Linked Bond ETF.

In spite of the efficiency of ETFs, they are not always the best solution for the investor. ETFs have no mechanism to reinvest quarterly distributions, although some investment dealers can do this for their clients, Atkinson says.

Investors who want to push bond returns up to the levels of equity returns can abandon the investment-grade universe of most bond funds and ETFs, and move to high-yield debt — a.k.a. junk. The concept makes theoretical sense: although junk bonds have a good deal of equity risk, they still have the preferred credit position that all bonds have in the event of the issuer’s bankruptcy.

Junk yields should surpass inflation rates, provided defaults do not drive down net returns. Defaults rise in business downturns, making junk portfolios very volatile. For example, Northwest Specialty High-Yield Bond Fund, which is usually at the top of its sector, has also hit the bottom of the sector performance in some calendar years. What is more, the 5.6% average annual compound return of high-yield bonds for the 10 years ended Oct. 31, 2005, was substantially lower than the 7.9% return of the SC universe bond total return index. The theory that high-yield debt will outperform investment-grade debt has not been borne out by recent experience.

The alternative way to beat inflation is to buy bonds that have returns hooked to the consumer price index. Canada’s real-return bonds are priced to pay a base return plus the CPI equalization adjustment. For example, a Canada 4.25% RRB due Dec. 1, 2026, has recently been priced to pay 1.45% plus the CPI adjustment. A comparable 8% Canada conventional bond due June, 1, 2027, has recently been priced to pay 4.13%.

The difference in yield, 2.68%, is the implicit inflation premium that investors expect and accept in buying the RRB. If inflation averages more than 2.68% for the next 15 years, the RRB investor will beat the holder of the conventional Canada bond. If inflation is less than 2.68%, the RRB investor will wind up with a loss relative to what he or she would have had with the conventional bond.

Is it reasonable to pay the premium and make a decade-and-a- half bet on the trend of the consumer price index? Yes, says Tom Czitron, managing director and head of fixed-income products at Sceptre Investment Counsel Ltd. in Toronto. “You are paying in order that you can sleep at night,” he says. “If governments make a mistake and fail to control inflation, you are protected. It’s the same as buying insurance for the possibility that your house may burn down. You hope that it won’t, but if it does, or if inflation soars, then the RRBs will turn out to have been more valuable than a conventional bond.”

Thus we go to the bottom line. How should one buy bonds? Concludes Crofts: “In fixed-income, you want to hold down fees, but also to know how much risk you are taking.”

ETFs have fees much lower than bond funds and can buy bonds far more efficiently than individual investors can. On the other hand, he says, an investor can buy risk and return experience with far more history in managed bond funds than in ETFs.

In managing risk and return, which are closely calibrated in bond markets, experience counts heavily. IE