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Here is the article from the Globe and Mail

FIXED INCOME

It sure looked rosy for bond funds during May. Look again

Despite rally, most funds still in the red

DALE JACKSON

They say every dog has its day. For bond funds it's been the past 30 days, thanks to a dismal month for resource stocks. Through the month of May the resource-heavy S&P/TSX composite index dipped 4 per cent, revealing bond funds as the undisputed champion of all mutual funds.

Bond funds were the best performing asset class in the entire Canadian mutual fund universe in May -- despite the fact that they barely broke even, and were the worst performing asset class in 2006 right up to the broader market plunge. So far this year only one of the roughly 125 Canadian bond funds have gained more than 1 per cent, and the overwhelming majority show losses.

To cite a typical example, the best performing Canadian bond fund in May also has the dubious distinction of being among the worst year-to-date performers. Even after its 30-day climb of 3.2 per cent, the SEI Long Duration Bond-O is still down 2.6 per cent for the year. As of May 1, the average Canadian bond fund had risen just 1.6 per cent over the past year and record low interest rates are only partly to blame.

"Bonds funds didn't improve, they just looked good next to everything else," says Hank Cunningham, senior vice-president and director of fixed income with Blackmont Capital. "The general correction in commodities and equities, and tough talk on inflation by the Fed took inflation fears away for the time being," he says.

Unfortunately for bond fund unitholders, those tiny gains in the bond market were trimmed by management fees and, in some cases, bad portfolio management, according to Mr. Cunningham. Good quality bonds rarely depreciate if they are held to maturity. However, if interest rates rise before maturity they lose market value because new bonds of similar duration pay better yields. Bond holders will only realize losses if they sell before maturity. When it looks like interest rates are heading up, bond fund managers will sometimes sell lower-yielding bonds at a loss in the hope of boosting returns from purchasing the newer, higher yielding bonds. Conversely, if it looks like interest rates are heading down, managers may sell existing, higher-yield bonds for capital gain.

"Bond fund managers just guess at interest rates," Mr. Cunningham says.

Mr. Cunningham contends bond fund unitholders are better off owning individual bonds to maturity -- even at low yields. The numbers back up his point. Over the past 20 years the average Canadian bond fund has consistently underperformed the benchmark Scotia Capital Universe Bond Total Return Index. "In a world with 4 to 5 per cent interest rates, when a fund manager is charging 2 per cent, there's not a lot left" he says.

Mr. Cunningham also believes bond fund unitholders are exposed to unnecessary risk when portfolio managers trade bonds on the open market. "When you need your money at the wrong time in the market cycle you might be in trouble," he says. For that reason he says bond funds should not be considered fixed income in an individual's investment portfolio.

"I would suggest a bond fund is fixed income," says Gregory Ross, senior vice-president of fixed income with Aegon Capital Management Inc. Even if returns are lower, he claims risk can be reduced through a managed bond portfolio.

Mr. Ross manages nearly $1-billion in fixed income, including the imaxx Canadian Bond Fund. Over the past three years, the fund has had an annual average return of 5.1 per cent, slightly lower than the benchmark index at 6 per cent and slightly higher than the group average return of 4.5 per cent. The fund holds a mix of government and large corporate bonds of varying maturities. So far this year, the fund has broken even.

The fund also has a management expense ratio (MER) of 1.87 per cent -- something Mr. Ross himself considers high.

John Braive, vice-chairman at TAL Global Asset Management, also believes individual investors should include bond funds in the fixed income portion of their portfolios because they are flexible enough to weather out a crisis in the bond market. "Bond fund managers have the ability to adjust the risk level" he says.

Mr. Braive manages the Talvest Bond Fund, which holds mostly government and corporate bonds. Over the past 20 years the fund has consistently underperformed its peers and the benchmark index. The Talvest Bond Fund charges unitholders a MER of 2.1 per cent.

Most bond traders agree the interest rate and bond yield trend is somewhere between flat and up, which means a slim chance for capital gains in the near future. But while bond fund managers say bond funds are the best place to be for fixed income investors, Hank Cunningham suggests a personalized, diversified fixed income portfolio and what is called a laddering strategy. Laddering a bond portfolio involves spreading terms-to-maturities consistently through several years. Having more bonds mature more often gives the investor frequent opportunities to get the best bonds at the best rates.

Dale Jackson is a producer at Report on Business Television

Bond world

Average Canadian bond fund returns

(as of May 1, 2006)

 Group AverageSC Universe Bond Total Return Index
1 month -1.07% -0.94%
3 month -0.99% -0.74%
6 month -0.07% 0.29%
1 year 1.57%2.64%
3 year 4.47%5.95%
5 year 5.20%6.95%
10 year 6.02%7.57%
15 year 7.29%8.76%
20 year 7.62%9.03%

SOURCE: GLOBEFUND



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