In Your Best Interest. W. H. (Hank) Cunningham
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in question does not give up any trade secrets to his counterparties (read competitors). Also, it means that each dealer does not have to make multiple phone calls to attempt a transaction. The IDB displays everyone’s bids and offerings electronically and pockets a brokerage fee on each transaction. These parties trade among themselves to offset transactions done with clients.
Last, we come to the individual investor whose needs are served by the different FIs. Individuals have their own specific reasons for purchasing fixed-income products directly: to generate income, to plan for retirement, and to provide safety of principal. They may need income in a foreign currency, they may wish to speculate on the price movement of bonds, or they might want to invest some money for future educational needs. Direct investment by individuals in the bond market, including GICs and ETFs, totals several hundred billion dollars.
The Case for Bonds
Why go through the bother of purchasing individual fixed-income securities? Why not take the easy route and invest in a nice bond mutual fund or ETF? The answer to the second question is that it is not in your best interest to do so! Mutual bond funds and ETFs simply do not offer the certainty required in retirement planning; their performance is erratic, and the management fees are too high. I speak from experience. For five years I managed what is now the largest mutual bond fund in Canada.
Sadly, there are too few IAs with sound enough working knowledge of fixed-income markets. The line of least resistance for them is to recommend bond mutual funds because they are an easier sell and the fees are attractive. However, they are not the ideal choice for the individual investor. Here are five reasons to choose individual fixed-income products.
Planning. Fixed-income products have specific maturity dates. That is, you know the exact date at which your principal will be returned to you and what your yield will be for the term that you hold this security. Contrast this with bond mutual funds: They do not have a specific maturity date, nor do they have a specified income level. Investors do not know what their investment will be worth at any moment or what it will be worth when they actually need their money back. Bond fund managers are constantly tinkering with their portfolios, shortening term, extending term, and trading for capital gains. This is not conducive to effective planning.
Fees. Bond funds charge management fees averaging approximately 1.66 percent per annum! ETFs offer lower management expense ratios (MERs). This takes a serious bite out of an investor’s income and return. Contrast that with individual products, where there is a one-time fee at the time of purchase (averaging 1/2 to 1 percent) with no further fees until they mature and the money is reinvested or if they are sold before maturity.
Performance. The long-term results of “professional” bond fund managers are not impressive, for a couple of reasons. First, it is a well-documented fact that no one is 100 percent sure of where interest rates are going. All forecasters, traders, and market commentators are right some of the time, but nobody is right all of the time. However, this does not stop portfolio managers from guessing using a technique with the more elegant name of “rate anticipation trading.” It only takes a couple of bad guesses for performance to suffer. Second, there is indexing in the bond fund management business, too, as brave portfolio managers huddle around the different bond indices in order to look good in the performance game and earn those bonuses for their professional management. They strive to beat the index as well as more than half of their peers so they will be able to market above-average performance. Also, consider that bond funds are required to calculate an annual return since they do not have a fixed maturity date. Investors owning individual bonds do not have to worry about annual returns since their yield and maturity date are known at the time of purchase. A good analogy is a baseball game. Individual investors in specific fixed-income securities know the outcome of the game before it starts even though the score (the annual return) may vary by inning. Bond fund holders have to worry every inning since they may have to leave the stadium before the end of the game without knowing the outcome.
It is difficult to have negative performance in the bond market.
Here are the annual performance results from 2002 for the broad Canadian Government Index and the Canadian Corporate Index as provided by Merrill Lynch Canada.
Corporate bonds just barely turned in a positive return in 2008 while the only negative performance came from government bonds in 2009. The principal reason for bonds to return positive returns on a consistent basis is the interest paid on bonds and the reinvestment of that interest. Granted that bond yields fell on a net basis since 2002, nevertheless there were lots of negative months. The bond market is one market where investors are advised not to sell into weakness.
Following is a table showing a group of Canada and corporate bonds with three-, five-, seven-, and ten-year maturities. Using current market yields, I increased the yield by 100 basis points or one full percent for a one- and two-year period. For good measure, I increased the yield by 200 basis points for the two-year period.
A few things stand out. For one, the lower the starting yield, the more negative the return for a given increase in yield. This makes sense as the income to be reinvested is less than that of higher yielding bonds. Thus, the corporate bonds would outperform all the government bonds for these scenarios.
The two-year total returns exceed the one-year returns for the same yield movement because there is one more year of compounding and because the bonds are now shorter in maturity by two years and thus less volatile.
Maturity Selection. Bonds come in a wide range of maturities, from thirty days to more than thirty years, allowing for appropriate retirement planning and ladder building (more on this in Chapter 8). Bond funds and ETFs do not have maturity dates so investors do not know how much money they will have when they need to redeem their units.
Liquidity. Bonds can be sold at any time, should raising money become important or should other opportunities present themselves. Daily trading volume averages over $38 billion, with the major investment dealers maintaining bids and asks on the complete array of fixed-income products that have been issued. Mutual funds can only be redeemed daily.
Bond Indices
There are several bond indices in the Canadian bond market. One of the most widely used for bonds in Canada is the DEX Universe Bond Index™ produced by PC Bond (www.canadianbondindices.com). This index encompasses some 1,103 different bond issues totalling some one trillion dollars and is constantly being rebalanced so that it fairly represents the overall bond market. As of December 31, 2010, it consisted of 46 percent in federal bonds and federal guaranteed bonds, 27 percent in provincials and municipals; and 27 percent in corporates. The corporates are further weighted by credit rating. The average duration was 6.27 years. Duration is a term that refers to the average term of the bond, taking into account the weight of the interest payments. Thus, duration is shorter than the term to maturity and is a measurement of the volatility of a bond. (More on this later.) This index is further divided into maturities with 45 percent being one to five years, 24.2 percent from five to ten years, and the balance of ten years and longer at 30.8 percent. There are many other sub-indices as well.
For the twelve months ending August 31, 2011, this index returned 5.35 percent while Canadian-managed bond funds returned a median of 3.50 percent. This gap is partly explained by the fees charged to the fund by the manager. This is called the management expense ratio (MER), which averaged approximately 1.7 percent in this period (source: globefund.com).
What to do then? I referred in the introduction to a strategy called laddering, which is fully explained later. Suffice it to say here that laddering takes the guesswork out of interest rates, reduces fees, and, over time, outperforms the majority of bond fund managers. This is done with individual fixed-income securities of staggered maturities. Basically, it is the most effective way of dealing with reinvestment risk, as your investments are spread out over regular intervals. This approach eliminates the need to guess which way interest rates are going, as investing in bonds of different maturities avoids the risk incurred if all your funds were invested in one maturity and interest