Bond funds are generally poor investments, with fees that are far too high, wiping out much of their returns and making them not worth the risk for the average investor, according to one prominent mutual fund analyst.

“With interest rates at multi-decade lows and the prospect of rate hikes ahead of us, many are leery of the outlook for bonds,” wrote Dan Hallett, CFA, CFP and head of Dan Hallett & Associates in Windsor, Ontario in a recent online column. “In my opinion, there are good reasons for this gloomy view. However, if that’s how you feel about bonds, you should be downright repelled by most bond funds.”

Hallett performed “an admittedly crude study” of bond funds, screening out those with high minimum investment thresholds and high-yield mandates — essentially allowing a comparison of “average” bond funds. This screening found an average MER of 1.87%. With mid-term bonds yielding just 4.4%, that leaves a net yield of 2.53%.

Only two funds managed 10-year returns that beat the index, after factoring in fees — Altamira Income and TD Canadian Bond, but Hallett points out the Altamira fund has taken “huge interest rate bets” and the TD bond fund allows for investment grade corporate bonds.

“Returns under 3% are unacceptable for the type of risk taken in a bond fund. In fact, that’s not much more than is available at ING Direct or other high interest savings accounts,” he said. “Hence, the challenge for advisors is to find fixed income solutions for clients offering return potential that is reasonably above that of risk-free alternatives.”

The two most visible high-interest banks in Canada, President’s Choice Financial and ING Direct, are currently offering a risk-free interest rate on deposits of 2% and 2.25% respectively, with the added benefit of easy access to the funds.

He says that direct investment into bonds would likely offer superior performance for the fixed income portion of a client’s portfolio, but admits this might not be feasible. Many advisors do not have securities licenses and regulators have been closing the door on brokerage correspondent relationships.

“The answer seems clear to me. In order to remain competitive, an advisor must have access to individual bonds. For larger clients, advisors can well afford to place some money with a low fee bond fund,” Hallett says. “It may be a cut in compensation overall, but I think clients would see that as fair since their returns going forward from this asset class are getting cut. Being fair to clients isn’t always a golden road but it is the path to building and maintaining a solid client base.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(09/07/04)