The case for bond funds

Bond fund managers face an uphill battle, trying to add value in an era when persistently low yields are often eaten up by management fees. But actively managed bond funds may still provide value, particularly in corporate debt space where corrections in credit markets have created opportunity.

The problem with fees on conservative bonds funds, such as those that invest in low-risk government bonds, is that management fees typically erode any value the fund manager would add. Yields are conservative, between 3% and 5%, and a prudent money manager would likely only be able to add about 50 basis points of out-performance by actively managing the portfolio.

An investor looking to create a long-term bond position would likely find more efficiency in buying bonds directly, or looking at some of the bond ETFs available in the market.

If an investor is only getting a 3% to 5% yield on bonds, is it worth investing in that space anyway? Independent industry analyst Dan Hallett, president of Dan Hallett and Associates, notes that with yields on high-interest savings accounts hoveri ng around 3% annually, investors are able to capture most of the current yield offered on longer bonds without the interest rate risk.

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If an investor wants to attain a higher yield than can be found in core bond funds, Hallett says it’s worth paying for the active management of a good bond manager.

“[Bond fund managers] can add value to the fees an investor is paying. When you’re into high yield, you’re really into a quasi-equity product. You’re investing in a universe where the [bid-ask] spreads are a lot higher. Most retail investors get their heads handed to them if they try to buy high-yield bonds directly anyway,” Hallett says. “You need that safety in numbers and diversification. Tough to do that on your own and you also have to put up higher amounts of money to buy those types of issues. It’s pretty rare to be able to buy a high-yield bond for $10,000.”

Even outside of the high-yield space, a bond fund manager can manage the downside risk of the credit markets, says Scott Lamont, head of fixed income for Vancouver-based Phillips Hager & North.

“It’s all about managing risk. A bond fund manager is trying to achieve the highest possible returns with as-low-as-possible volatility. They need to strike a good balance between the two,” he says. “Certainly a good active manager can reduce risk at the appropriate times. I think a good example of this was early last year when credit spreads were extremely narrow. At that point in time we were underweight corporate risk, which is relatively unusual for us. If you owned an index fund or an ETF you don’t have that latitude.”

The subsequent contraction in the credit markets has hammered a lot of high-quality debt issuances, which means bond fund managers are seeing opportunity to increase yield at prices that are at decade-lows, Lamont says, pointing to Canadian banks as an example.

“You’re currently able to buy five-year bonds of senior ranking Canadian banks in the range of 150 to 180 basis points above a similar trade-order of Canadian government bonds,” he says. “It’s an environment we haven’t seen in many decades. It does provide a certain return advantage to holding high-quality corporate bonds.”

Lamont notes bond funds also have the advantage right now of having the scale to hold illiquid forms of high-quality debt, which pay a higher yield.

“Canada housing trust bonds are yielding in the range of 40 to 50 basis points over similar term Government of Canada bonds,” Lamont says. “That’s one of the advantages of going the pooled fund route: you’re paid a substantial premium to own securities that have less liquidity. If you own the bonds individually and have a need for cash, you have no one who will give you that money in the marketplace. We would not have to sell those securities to fund normal course redemptions.”

As you move more into the high-yield space, Lamont stresses the risk management of the manager becomes even more important. For example, his firm tries to take a crossover approach on high-yield debt by focusing on higher-rated corporate securities.

“Our high-yield fund is a little bit different from a lot of the high yields out there. We have our high-yield fund in place for more than 10 years, and over those 10 years it’s had more emphasis on BB and BBB securities, which are investment grade securities,” he says. “The typical high-yield bond fund will focus on the single B area of the marketplace.”

Lamont says PH&N will tend to take this more defensive position in a low-rate environment in corporate debt.

“We have moved very substantially to a high-grade portfolio when we thought rates were unattractive,” he says. “Right now, the reverse is true; we think the credit markets are going to continue to evolve, where high-yield credits will get cheaper over the next few months; when they are attractive, our tendency will be to move down the credit spectrum.”

All of this active management will be for naught if investors pay too much for it, Lamont stresses. He says keeping fees under control is a crucial aspect of efficient fixed-income investing.

“I want to reinforce, all of these comments are relevant only if you’ve got a fund with low fees, because that’s particularly important in a low interest rate environment,” he says. “What you need to look at are returns after fees, and compare that to what you’re going to get with an ETF or index fund fees. Remember, with an ETF, you’re also going to have brokerage fees and advisor fees. The comparison must always be made on an apples-to-apples basis — which is after-fee returns. You’ll find the low-fee active managers do very well under that comparison.”

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

(08/11/08)

Mark Noble