Frugal Fixed Income
The PH&N Bond Fund
Most Canadian bond funds invest primarily in staid but secure Canadian
government bonds and add value through smaller holdings of
higher-yielding corporate issues. High yield bond funds provide an
alternative that focuses on corporate issues. Corporate bonds come
with higher risk, but also with greater potential returns. A third
income-producing option is the new class of income trust mutual funds.
It is important for investors to understand that income trusts carry
much greater risk than bonds.
The benchmark against which returns of investment grade debt are
generally measured is the Scotia Capital Markets Universe (SCMU)
index, which tracks the performance of over 900 Canadian bonds. This
index is very difficult to beat on an after-cost basis. Indeed, over
the past ten years the average Canadian bond fund returned an average
of 6.8% annually. The index on the other hand yielded 8.4%.
The past twenty years have seen domestic interest rates come down
from historic highs reached in the early eighties to the lows of
today. The result has been remarkable bond market performance that
kept close pace with equities. This is a peculiarity of the recent
history of Canadian interest rates and is unlikely to be repeated.
Furthermore, with rates more likely to increase than decrease,
investors' expectations of fixed income returns must be tempered.
Since bond funds generally underperform the SCMU benchmark and are
expected to have lower returns going forward, cost becomes a very
important consideration. The median management expense ratio (MER)
for Canadian bond funds is 1.64%, though individual MERs go as high as
3%. For high-yield bond funds, which focus on riskier corporate
issues, the median is slightly higher at 2.0%. Frugal investors
should stick to bond funds that charge an MER of no more than 1%.
Fortunately there are a number of high quality low-cost bond funds
available. These include funds offered by Phillips, Hager and North,
McLean Budden, and Leith Wheeler. Vancouver-based Phillips, Hager,
and North (PH & N hereafter) is mainly a pension fund manager.
However they also offer mutual funds that are very attractively
priced. The PH & N Bond fund, which is the focus of the rest of this
article, offers conservative management with a very enviable track
record for the rock-bottom cost of 0.58%.
Phillips, Hager, and North Bond
Over the past twenty years, the PH & N Bond fund returned an
average of 10.5% annually, just slightly underperforming the SCMU
index which yielded 10.6%. The fund has consistently kept pace with
the index since its inception in 1970. Over the last year, as
domestic interest rates reached a bottom and began to rise, the fund
gained 9.4%, beating the index's 9.1% return. Income distributions to
unitholders accounted for over half of the one year return.
Managed by Scott Lamont, a member of the PH & N Fixed Income team,
the fund invests mainly in government and high-yield corporate bonds
rated BBB or above (using the Dominion Bond Rating Service scale). It
also buys Canada Mortgage and Housing Corporation backed mortgages.
Having exposure to a wide variety of issuer classes is but one facet
of the fund's active multiple strategy approach. Interest rate and
yield curve strategies are also used, which reflects Mr. Lamont's
belief in strategy diversification as the best way to add value over
the long term.
A core of Canadian government bonds representing no less than 30%
of assets provides the fund with liquidity and ensures a minimum
credit quality level. A highly diversified portfolio of carefully
selected corporate bonds, on the other hand, serves to enhance the
fund's yield. Indeed, the corporate sector has been a main focus of
the fund's recent strategy, and the fund is currently overweighted in
that category. Corporate bond selection relies on both top-down
economic analysis, and bottom-up analysis of specific issuers and
bonds. Throughout the process the fund's emphasis is on controlling
risk and avoiding making any "big bets".
Illustrating its active management style, the fund began the first
quarter of 2003 with a 15.6% cash position. However, by the end of
the quarter that had dropped to 1.7% as the fund deployed its cash.
Roughly two thirds went to purchasing federal government bonds, while
the balance was mainly invested in corporate issues. At the end of
the first quarter, the fund held 122 securities. Of these, nine were
Canada bonds making up 43.4% of the portfolio and ninety-one (or
33.3%) were corporate bonds. The single largest corporate issue was a
4.35% GE Capital Canada Funding Company (GE) bond maturing in February
2006 representing a little over 2% of assets and rated AAA. The
portfolio's effective yield was a healthy 5.3%.
In terms of maturities, the fund trimmed its short-term holdings
during the quarter in anticipation of interest rate increases and
ended up with a bullet structure, which favours medium-term bonds.
Issues with between one and ten years to maturity made up 53% of the
portfolio, and the average term was 9.7 years. However, the fund's
overall sensitivity to interest rates increased only slightly,
continuing a long-term trend.
Over the past twelve months, which saw an end to the domestic bond
market rally, the portfolio's aggregate properties remained fairly
stable. The fund's components, however, were not static. Until this
past quarter, federal government holdings had been steadily pared back
while cash reserves increased. At the same time the fund continued to
increase its exposure to provincial and corporate bonds. These shifts
had the effect of decreasing the portfolio's share of AAA-rated bonds.
However, a corresponding drop in the number of BBB-rated bonds helped
ensure that overall credit quality remained essentially unchanged.
One slightly negative aspect of the fund's active management style
is its high turnover. Over the past five years turnover has been on
an upward trend and averaged 287% per year. Mr. Lamont states that
this is an expected side effect of the fund's emphasis on multiple
strategies. Although it has not prevented the fund from outperforming
its peers, the recent trend is a source of concern as it represents
increasing brokerage costs that are not reflected in the MER.
It is worth pointing out that the PH & N Bond fund's 0.58% MER is
not only lower than that of most of its actively-managed peers, it is
also lower than that charged by most bond index funds. For a minimum
investment of $25,000 the fund is available to all investors either
directly through Phillips, Hager & North, or through dealers. A
rock-bottom MER combined with a superb long-term performance record
makes the PH & N Bond fund a bargain and worthy of inclusion in
Remember that bonds are expected to underperform equities over the
long term, recent Canadian history notwithstanding. Also, in the near
term, rising interest rates will limit bond funds' upside potential.
Therefore, now more than ever, it is crucial to select low-fee
Carl Wolfe, PhD