Understanding Bond Funds

Question: Each spring and fall, we see advertisements promoting Ontario and Canada Savings Bonds. As part of our investment portfolio we have some bond funds. My sister says we should only have bonds, not bond funds. Who is right?

Answer: This is one of those questions where there isn't a right or wrong answer. It can often depend on your particular financial situation.

First, let's review the major differences between the two. Bonds, on the surface are simple. If you buy a bond, you'll receive semi-annual interest payments until maturity and then get your money back. Bonds are "stand-alone" products. You need a fairly large investment to purchase sufficient bonds to "play" the bond market. To diversify in the bond market, you need an even larger asset base to start with.

With Bond Funds, you and many others, pool your financial resources together. You make your money off interest paid by the bonds in the fund. You also gain on the buying and selling of bonds within the portfolio. By paying management fees to the bond fund manager, you achieve economies of scale and diversification.

When you buy a bond, it's a retail bond purchase. You are buying the bond out of the inventory of an investment dealer, who acts as a principal on the trade. The dealer makes its profit on spread. Because the bond market is not an auction market like the stock markets, it may be inefficient. That inefficiency leads to price differences between what institutional customers pay for very large bond transactions and what relatively much smaller retail customers pay.

Bond funds are investment funds (mutual and/or segregated funds). It is probable that what the investment fund manager pays for a fund is much less than what an individual would pay. This, combined with the benefits of diversification and the value of professional management, should justify the management fee.

Bond funds offer other advantages. Funds employ active management and will adjust duration to maximize capital gains in an interest rate down trend and preserve capital in an uptrend. Generally, longer-term bonds, say those with 10 years or more to maturity, get hit hardest while short-term bonds get off easy. A good fund manager will play on credit-spread contractions as markets come out of a recession. The fund manager can hold a broader range of bonds (short and long term bonds), including higher yielding corporate issues, because they have the size to be well diversified when they do so.

To answer your question, there is nothing wrong with either approach. For most of us that have limited financial resources, bond funds would best serve us in our overall portfolio allocation.

The information contained in this article is intended to provide general guidelines only. The material herein is provided solely for informational and educational purposes and is not to be considered as an offer or solicitation for the sale or purchase of any investments or insurance. The application and impact of the law can vary from case to case based on the specific or unique facts involved. Accordingly, the information in this article is not intended to serve as legal, accounting or tax advice. Users are encouraged to consult with their professional advisors for advice concerning specific matters before making a decision.