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Bargain Bonds

With short-term interest rates at historic lows and seemingly poised for an increase, what are fixed-income investors to do? When interest rates do start to rise bond prices will fall, spelling unhappy news for bond holders. The very defensive might choose to sit on the sidelines and hold cash in money market funds or in GICs. But with traditional one-year GIC rates topping out at about 2.6% and most money market funds not doing much better of late, this option is not terribly appealing.

It may well be prudent to move some fixed-income assets into shorter-term high-yielding GICs, but it's probably also a good idea to retain some exposure to bonds. One way of giving your fixed-income investments an edge in such a climate is to reduce carrying costs as much as possible. Directly holding a diversified portfolio of bonds for the long term is the most economical option for those with the means to do so. However, the rest of us will most likely want to make use of fixed-income funds.

Cost, as summarized in the management expense ratio (MER) is of course always important when selecting an investment fund. However, it should be front-and-centre when selecting fixed-income funds (and even more so for money-market funds). The reason for the added emphasis is simple: Fixed-income returns are likely to be smaller than equity returns over time. A given MER will then gobble up a greater proportion of a bond fund's before-fee returns.

To illustrate the impact of fees, let's consider two bond funds with equally skilled managers that charge, respectively, 1% and 2% annual MERs. Assuming that both yield an average of 8.6% annually over ten years before fees, then after paying the MER, investors in the first fund will see returns of 7.66% annually while investors in the second fund will see only 6.66%. On an initial investment of $10,000 the difference after ten years amounts to $1970 (18% of the cheaper fund's total gain), in favour of the low-fee fund.

The median MER charged by open-ended Canadian bond funds is about 1.6%. Frugal investors should stick to bond funds that charge no more than 1%. Worthy contenders in this category include funds offered by PH&N, Beutel Goodman, and Legg Mason. Investors now also have access to Canadian fixed-income indexing through the TD e-Fund series and, in a limited fashion, via two exchange-traded funds (ETFs). In the rest of this article I take a closer look at the Legg Mason Index Plus bond fund, which is an index fund by name but not by nature, as well as the iUnits five- and ten-year government bond ETFs.

iUnits iG5/iG10 ETFs

In November of 2000 Barclay's Global Investors began offering two government bond ETFs. The five year iG5 (TSX:XGV) and ten year iG10 (TSX:XGX) funds each offer investors low-cost access to a single Government of Canada bond with close to the indicated time to maturity. The iG10 portfolio consists entirely of a Government of Canada bond with a 5% coupon maturing on June 1st, 2014. Similarly, the iG5 holds only a 5.5% coupon bond maturing on June 1st, 2009. At some time in the next twelve months these holdings will be completely sold and replaced with bonds maturing in 2015 and 2010.

Since the maturity of the portfolio is locked in by design, holding one of these ETFs is similar to using a ladder strategy with directly-owned bonds that maintains the same average maturity. The major difference, besides not having to put up the large amount of principal to buy the bonds directly, is that owners of ETF units don't have to worry about reinvesting the principal amount of the shortest bond in the ladder upon its maturity. The price of this convenience is a very modest 0.25% annual MER on top of any brokerage commissions.

On the downside, these ETFs offer exposure only to government bonds, and no long-maturity option (like, say, a 30 year bond) is available, which limits the portfolio construction possibilities. For example, it would be impossible to build a portfolio of ETFs with an average maturity of greater than ten years. For the record, as of April 30th, the $241 million iG5 and $70 million iG10 ETFs had one-year total returns of, respectively, 7.2% and 7.4%, to be compared with the 6.6% and 7.6% returns of bond indices with comparable maturities.

The iG5 and iG10 ETFs are suitable for small conservative investors who are investing for the long term, who want a regular income stream with the possibility of modest capital gains, and who seek the relative security attached to government bonds. iUnits ETFs are available through dealers and brokers. Investors looking for the more generous yields available from corporate issues should look to more active management.

Legg Mason Canadian Index Plus Bond

The conservatively-managed Legg Mason (formerly Perigee) Canadian Index Plus Bond fund has a long record of solid performance. Over the past fifteen years it has yielded an average annual return of 9%, which exceeds the returns of the average Canadian bond fund by about one percent. True, it also trails the 9.7% annual performance of the Scotia Capital Markets Universe (SCMU) index, but only by an amount equivalent to the fund's annual 0.72% MER. This means that the fund's portfolio has, before fees, closely matched the index's performance over time.

The fund is managed by the team of Marlene Puffer, Ron Puskarich, and Derek Knie, and it invests in Canadian bonds rated BBB or higher (on the Dominion Bond Rating Service scale). In practice though, most of the fund's holdings are rated at least A. To add value the managers use a combination of active management and index tracking using the SCMU index as a benchmark. For example, the fund's duration, which measures its sensitivity to changes in interest rates, is maintained within a plus or minus one year range around the benchmark duration. However, within this range Ms. Puffer takes active bets on duration to take advantage of anticipated interest rate fluctuations. The weights of corporate bonds relative to their benchmark weights are also actively adjusted to take advantage of changes in yield spreads.

To guide the fund's bet-taking, the managers rely on in-house statistical models for a variety of factors that drive interest rates and corporate spreads. With these models in mind the managers watch for conditions that carry a high likelihood of rate and/or spread changes and position the fund to take advantage of the anticipated changes. Although the fund is active, it is worth noting that its average asset turnover, at 46%, is not particularly high.

At the end of April the fund held $138 million in assets in about 76 distinct bonds. Corporate issues made up the biggest part of the portfolio at 35% of assets, a proportion that was essentially unchanged since the end of 2003. Government of Canada bonds represented 30% of the portfolio down from 37%, provincial bonds were at 20% down from 25%, while municipal bonds were at 5.6% up from 2.4% on December 31st. The fund also held a 6% cash position. Two of the fund's top three holdings were federal government bonds, and the third was issued by Canada Housing Trust. Together these three bonds accounted for just over 20% of the fund's assets.

Over the last year or so the fund's strategy has been largely defensive, with excursions being limited to short-term tactical moves. Accordingly, at the end of the first quarter the fund's duration was slightly shorter than the benchmark's, making it a bit less sensitive to interest rate changes. In addition, the fund's term structure had a "modestly" bulleted shape, which means that there were slightly more bonds with medium-term maturities than short or long bonds.

Ms. Puffer declined to comment on her expectations for domestic interest rates going forward. However, based on the positioning of the fund at the end of the first quarter it can be reasonably deduced that she would agree with the general expectation that rates will start to increase over the coming year. As a result the fund can be expected to maintain its defensive posture for another little while.

A low $2500 minimum investment makes the Legg Mason Canadian Index Plus Bond fund accessible to most investors, and it is available through dealers and brokers in all provinces. With a near rock-bottom MER, a comparatively low turnover, and a cautious outlook, the fund is appropriate for cost-conscious conservative investors who seek a moderate level of income. More aggressive investors may want to also consider the Legg Mason Canadian Active Bond fund, which is managed in the same manner but takes bigger bets.

When selecting a fixed-income fund remember that each additional basis point paid in MER takes your possible returns that much further away from the index's performance. Sticking to low-cost funds will help to ensure that more of your money continues to work for you.

Carl Wolfe, PhD

July 2004

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