In this month’s Faceoff, Dan Hallett, Director of Asset Management at HighView Financial Group and Avery Shenfeld, the managing director and chief economist at CIBC World Markets, square off on the issue of bond funds.

Hallett’s take

With the prospect of a gradual recovery — despite the volatility of the last couple of weeks — interest rates will eventually rise, and bond prices will fall. But bond investors shouldn’t panic. High-quality bonds are less volatile than stocks even during rising rates. Unless you’re holding long-term bonds, you should recover quickly from any decline in bond prices.

When it comes to sensible investing, economist Benjamin Graham wrote, “If you don’t know how to spread your assets, put half in stocks, and the other half in bonds and cash, then rebalance periodically.” My investment philosophy is to make a big bet in favour of or against an asset class by using the 75:25 parameter — invest at least a quarter of your assets in stocks (but no more than three-quarters), and the rest in cash, fixed income products and other asset classes.

There’s a role in every portfolio for bond funds as a source of stable income, even if it’s not very high income. Though economies around the world are slowing, there’s still enough stimulus sitting in the global financial system to make inflation a long-term risk. It could spike higher than markets expect. Some bond classes, like real-return bonds, provide a safe hedge against unexpectedly high inflation.

Historically speaking

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We haven’t seen a bond bear market in North America where losses exceeded the low double-digits. In the two cases where it did happen, the bond market recouped fairly quickly. Even 1994 — the worst bond market in the history of North America, where interest rates rose very quickly — was followed by what turned out to be one of the best years on record for bonds.

It’s not just the magnitude, but also the speed of interest-rate increase that impact losses. For slow-rising interest rates, the price impact from year-to-year, or even quarter-to-quarter, is minimal. And if the rise is gradual, the interest component can cushion the fall in prices. As interest rates rise, and bonds are turned over in the portfolio, you grab higher yields that have an increasing rate of return over time.

Bonds vs. bond funds

It takes more money to buy a bond than a bond fund. Depending on our clients and their portfolios, we have a structure where they can get bond exposure directly or have bond allocation through funds. The more investable assets they have, the more economical it is to buy individual bonds — the larger the portfolio, the lower the percentage cost overall.

For everybody else, a fund or exchange-traded fund (ETF) makes more sense. For example, a client with a seven-figure portfolio could get direct exposure to individual bonds. Everyone else with a six-figure or even low seven-figure portfolio is better off with a bond fund.

With existing yields, fewer people are buying single-investment bonds. When yields were 6 to 7% it made sense, but in today’s market, when you go long on the yield curve and don’t even get 3%, most look at some combination of government and corporate bonds instead.

While government bonds offer some measure of security, individual corporate bonds become trickier to pick because they are riskier and require higher credit-risk diversification. Again, a reasonably priced bond fund or ETF adds more value because they provide better diversification and liquidity.

Clients in the accumulation phase invest on a regular basis. You can’t do that efficiently with bonds. The best you can do is invest in a bond fund that makes enough money to buy a bond.

Managing MERs

Bonds and bond funds, particularly non-government class, offer a lot of benefits. The only flip side: their exorbitant MERs. As yields come down, the fees, which are more or less fixed, take up a larger proportion of the growth YTM. Investors seeking advice will incur expenses, whether they pay directly to a portfolio manager or into a fund.

Get around high MERs by investing in less expensive funds. In every bond fund category there are well-priced, high-value options available. For example, some bond funds pay the full half-percent trailer commission to an advisor and are only priced at about 1% a year, instead of 1.5%.

Tread a balance between keeping an eye on costs for clients and providing them with the exposure they need, while still getting paid a reasonable amount. Find a product that has the pooling aspects of funds: flexibility, diversification and liquidity, and as a result, pricing.

Shenfeld’s take

In the near future

For bonds to do well in the coming months, either the Bank of Canada has to cut interest rates or inflation has to melt away. Neither is likely. So odds are, yields will rise and bond funds will perform relatively poorly.

The most likely scenario is bond yields will drift higher over the next year and a half. However, there continue to be enough uncertainties in the global economy; you should have some of your portfolio in a bond fund as a hedge against those what-ifs.

On the whole, bond funds should be treated as insurance in a portfolio rather than income generators. Over the past few decades, bond-fund returns were amplified by a gradual decline in long-term interest rates from high levels in the early 80s. Given how low yields already are, that excess return cannot be realized over the next two decades. So other assets will likely provide better returns over the next year and a half.

Look elsewhere

For those interested in yield, I suggest Real Estate Investment Trusts (REITs). The current yield on properties owned by real estate funds is higher than yields on a typical bond fund. Current properties are well rented, occupancy is good, and there isn’t much vacancy in Canadian commercial real estate. So REITs offer a superior and reasonably safe return.

After the correction in equities, some parts of the stock market will also offer better, longer-term returns. Some equities that pay stable dividends are now offering higher yields than a typical bond fund. They are still risky but over the long run, if those dividends are backed by profit, they may offer a higher long-term return.
Preferred shares are another asset class with a healthy yield. If investing outside a registered plan, preferred shares have an added edge because of the dividend tax credit. Income will be taxed at a lower rate than if it comes from a bond, which pays interest.

One size doesn’t fit all

All investors should have some assets in fixed-income funds, given the current uncertainties around the global economy, but the proportion depends on risk tolerance, age and other factors.

Older Canadians, well into their retirement years — when preservation of previous savings is more important than growing the nest egg—tend to have a higher proportion in fixed-income assets, including bond funds. Younger investors with longer time horizons can definitely afford to have more of their assets in stocks.

Asset mix also depends on the portfolio size. Investors with large portfolios might create their own diversified pool of bonds; others with less to invest might find that to be more expensive than having their money managed in a fixed-income fund.