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How bond funds can guarantee weak returns

bond funds

Bond funds may have performed well in the past, but nowadays they are more likely to be dead weight in your portfolio.

Bond funds are ETFs or mutual funds that invest most of their assets in government or corporate bonds.

Until a decade or so ago, many bond funds posted strong results, with yields of 6%, 8% or 10% over five or 10 year periods. 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.

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Interest rates have fallen in response to the subprime mortgage crisis and the recession, and are now near the low end of the historical scales. That means bond funds are unlikely to perform as well over the next few years, since interest rates do not have much further to fall. In fact, interest rates will likely hold steady or even rise. This means the 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 substantially lower, it makes a lot less sense.

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

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

As a general rule, the safest bonds are issued by or guaranteed by the federal government. Next come provincial issues or bonds with provincial guarantees.

Corporate bonds are far riskier than government bonds, and the risk on corporate bonds, varies widely. Some corporates are almost as safe as government bonds and offer only slightly higher yields. Some corporates are far riskier and offer far higher yields.

Here are 3 tips for investing in bond mutual funds

1. Avoid mutual fund managers who trade heavily

Some of the most dangerous funds are those run by managers who honestly believe they can increase their performance by frequent in-and-out trading. Many of these managers fail to realize how close their mutual fund’s performance comes to disaster each year, until disaster finally strikes.

If you add up a heavy trader’s losses at the end of a given year, they may amount to a high percentage of their fund’s assets (25%, for example). That may seem perfectly acceptable to the mutual fund manager, so long as the profits on their winning trades are significantly higher than that (for example, 75% of assets).

If the mutual fund manager guesses wrong a few times, however, it’s all too easy to reverse those figures: that is, have losses totalling 75% of assets and profits totalling 25%, so that the mutual fund loses 50% of its capital. If the manager delves into low-quality or highly volatile choices, as heavy traders are apt to do, then the mutual fund’s performance can drop.

2. Beware of buying vaguely described bond mutual funds

Get rid of bond mutual funds that show wide disparities between the mutual fund’s portfolio and the investments that the sales literature describes. Many mutual fund operators describe their investing style in vague terms.

It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at a mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. When the bond mutual fund takes on a lot more risk than you’d expect—perhaps by overweighting riskier corporate bonds over government bonds—our advice is to get out.

3. Avoid buying bond funds with anonymous managers

This includes buying mutual funds run by committees. The trouble here is that the brains of the mutual fund may leave, and investors would never know it until they saw the drop in their mutual fund’s performance.

For some investors, bonds may be attractive for predictable income, and as an offset to the volatility of stocks in your portfolio. But it’s cheaper to buy bonds directly than to do so through a bond fund. If you want capital gains, buy stocks or stock-market ETFs.

Are you invested in bond funds? Have they been profitable for you? Share your experience with us in the comments.


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