How Bond Funds Can Guarantee Weak Returns

Bond funds are mutual funds that invest specifically in different government and corporate bond offerings.

Many bond funds built great performance records in the last decade. You can find lots of bond funds that have yielded 6% or 8% or 10% over the past five or 10 years. This, though, was a function of the trend in interest rates; at the start of those periods, the funds were buying bonds with higher yields than bonds offer today.

As interest rates fell, the value of their bond holdings rose. This added capital gains to the interest the bond funds produced.

Even though interest rates have recently fallen in response to the subprime crisis, bond funds are unlikely to perform as well in the next few years as they have in the last few, since interest rates do not have as far to fall. In fact, interest rates may remain steady or rise. That means bond funds would only earn interest income on their bonds; instead of capital gains, their bond holdings could produce capital losses.

When bonds yielded 10%, perhaps it made some sense to buy bond funds and pay a yearly MER of, say, 2%. Now that bond yields are down closer to 4%, it makes a lot less sense.

The bond market is highly efficient and few managers of bond funds can add enough value to offset their management fees. But in addition, investing in bond funds exposes you to the risk that a manager will gamble in the bond market and lose money.

Another threat to bond funds is inflation. If bond funds hold their bonds to maturity, they get back the full amounts, but inflation will have cut the purchasing power of the bond’s face value.

If you do need steady income and want to hold bond funds, here is a fund that has low fees and top-quality holdings, and that stays out of speculative trading.

ISHARES CANADIAN SHORT BOND INDEX FUND (Toronto symbol XSB) is a fund that mirrors the performance of the DEX Short Term Bond Index. This fund holds a diversified range of investment grade federal, provincial, municipal and corporate bonds, with terms to maturity of between one and five years.

Top issuers include the Government of Canada, Canada Housing Trust, RBC Capital Trust, the Province of Ontario and the Province of Quebec. The average term to maturity of the 99 bonds held by the iShares Canadian Short Bond Index Fund is currently 3.1 years.

Expenses for the iShares Canadian Short Bond Index Fund are 0.25% of assets per year. The fund has a current yield of 4.4%.

iShares Canadian Short Bond Index Fund is a recommendation of Pat McKeough’s Canadian Wealth Advisor newsletter.