Fees can make or break bond investing

Recent volatility in the equity markets has sent investors fleeing for safety — money-markets dominate fund sales, and government bond prices have been on the rise. But investors must pay close attention to the fees they are paying for bond funds, which may drastically reduce any gains to be had.

If your clients are interested in increasing their allocation to bonds or money market funds, it’s most likely because they’re looking for either an income stream or near risk-free returns.

If the upside potential of an equity fund is high, a higher-than-average fee might be tolerated. When it comes to bond investing in a low-rate environment, in which a “safe” rate of return should fall in the three to five per cent range offered by high-quality or government bond funds, paying more than 1% in fees doesn’t make much sense.

Dan Hallett, president of Dan Hallett and Associates, has been making this argument for some time. He says fees on conservative or core Canadian bond funds are just too high, given the low-interest-rate returns they yield. Hallett says bond fund management plus financial advisory fees should ideally be no more than a 1% management expense ratio — or 0.75% for investors buying funds without an advisor.

“Bond funds for sort of plain vanilla bond investing are kind of useless because the vast majority of them have fees that eat up a big chunk of the yield available on fixed income,” he says. “In terms of what options are available for investors, there are still some relatively low-fee bond funds available to them, but there aren’t many of them.”

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The two major alternatives in the market for retail bond investors are buying bonds directly through a brokerage or looking to get bond exposure through a low-cost ETF.

Som Seif, president of ETF provider Claymore Investments, is an advocate of using ETFs for bond investing if an investor doesn’t meet the minimum investment threshold to get a institutional discount on bond purchases. Seif says once you strip out the fees from Canadian fixed income funds, there hasn’t been a single one in Canada that has outperformed its benchmark over the past 10 years.

“It’s very difficult for managers to add value in fixed income investing,” he says. “When you talk to an institutional investor about what their desired fixed income manager would achieve, they are hoping to generate 50 basis points of returns above an index. If they can do that, they have done a fantastic job of adding value in the fixed income space.

He says that if a fund has an MER of more than 50 bps, it will eat up most of the expected return. He also points out that some active bond funds have an MER of between 125 bps and 150 bps.

Claymore offers the Claymore Ladder Bond ETF for 15 basis points (0.65 basis points for the advisor class), which Seif says creates a laddered bond strategy that is cheaper than even doing it yourself. It’s not a traditional ETF in the sense that it tracks a customized bond index created by Dex and not one of the widely used indexes.

“It rebalances once a year, so there is less rebalancing than you find in the indexes,” he says. “We buy the bonds and hold them close to maturity; five bonds in five buckets, 25 bonds total. When the one-year bucket expires in one year, you’re now rolling that over and buying the five-year bucket.”

There are other ETF options available that offer exposure to the real return bond index, giving the investor inflation-adjusted returns.

Heather Pelant, head of iShares for Barclays Global Investors, says the iShares Real Return Bond ETF has been one of its best-selling products among both institutional and retail investors looking for low-cost inflation protection for their portfolios.

“We’ve seen a lot of institutional and retail investors who believe we are entering an inflationary time period,” she says. “Concerns about bonds are significant because we have an aging demographic in need of fixed income. Bonds are going to be an incredibly important part of a portfolio now and in the future.”

Pelant personally believes fixed income, even more so than equities, is where ETFs will ultimately demonstrate the most value.

“Firstly, overall yield and returns on bond funds tend to be lower. Secondly, bonds are a notoriously difficult asset class for a manager to add value in. Thirdly, investors have resorted to hokey and less nimble ways of doing bonds,” she says. “Many investors have told me that when it comes to managing bonds, they always feel like there is less precision. They don’t have the same precise level of strategy, so they buy a bond fund or they build a bond ladder. There hasn’t been a ton of viable options.”

Using ETFs exclusively for bond exposure is not without its own risks, Hallett notes. He says whether investing directly in bonds or choosing an ETF, investors can suffer from cash slippage.

“Certainly one of the disadvantages of the ETFs — and this applies to direct bond buying as well — is you can’t invest a specific dollar amount. For example, if you have $59,912.52, some of that will not get invested in bonds. You have to use specific amounts on an ETF or a bond,” he says. “That’s where a bond fund comes into play. In that case, you can justify a somewhat higher fee on the fund because you’re fully invested no matter what the dollar and cents amount is on the minimum for the fund.”

In addition, he notes semi-annual coupon payments usually can’t be efficiently reinvested directly into bonds. Hallett views this as an indirect cost, or opportunity cost, and says it can be minimized by reinvesting those odd dollar amounts into a reasonably priced bond fund.

In the case of investors who try to buy bonds directly, Hallett says they run the risk of being fleeced by deceptive brokerage sales tactics. Bond brokers can take a hefty chunk out of the yield spread if an advisor or client doesn’t do his or her homework.

“You don’t get charged the $10 to $20 commission that you [are charged] when you buy a stock. Basically, what happens is they quote you a price in the yield. If their commission is lower, your price and yield is higher,” he explains. “You have to try to be informed on the wholesale rate and compare that to what you’re getting. That’s a much harder thing to do versus finding out stock prices.”

On Monday: The case for bond funds

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(08/08/08)

Mark Noble