Expert discusses advantages and disadvantages of bonds and GICs over bond funds
On the back of a nearly five percent increase in interest rates over the last two years, yields on bonds and guaranteed investment certificates (GICs) have risen. On the other hand, the average Canadian ‘fixed income’ fund has seen an astounding decline rate of 11.5 percent in 2022 and a further 1.7 percent this year.
Dale Jackson of BNN Bloomberg has shared his insights on reconsidering investments from choosing bond funds to bonds and GICs. He said bonds and GICs are considered fixed income given they have a set yield and a set maturity date. Investors get an idea of the exact amount they receive at a time.
Meanwhile, investors are uncertain about the yields from bond funds because their investments are in a portfolio of fixed-income securities that are often traded on the broad bond market several times before maturity. “In a rising interest rate environment, the yield on bonds at any given time is higher than it was in the past but lower than it will be in the future, which lowers its present value on the bond market,” said Jackson in a report.
Rising interest rates being ideal environment for bonds
David O’Leary, founder of Toronto-based Kindwealth, said the average interest rate on the bonds since interest rates have been rising. “Bond prices are inversely correlated with interest rate changes,” he told Jackson in a discussion about yields of bonds and bond funds.
“If I own a 30-year bond paying three per cent interest and interest rates go up to three per cent, no one will want to buy that bond from me unless I lower the price because they can just buy a new 30-year bond paying five per cent,” he said.
“On the flip side, if interest rates go down, my existing bond will be worth more because the new bonds being issued are only paying, say, 2 per cent. So, they will pay me a higher price for my 3 per cent bond.”
In his report, Jackson discussed the reasons behind the finance industry pushing bonds as fixed income. He notes a ‘properly’ diversified retirement investment portfolio will include a fixed income component to stabilize the portfolio against volatility, which would depend on the investor’s risk tolerance and preferred time horizon. He also said advisors get big commissions from bonds whereas accessing bonds directly would mean no compensation to advisors from investors.
“Bond funds also provide big commissions for the advisor. Annual fees on bond funds (known as the management expense ratio or MER) can be as high as 2.4 per cent of the amount invested. Baked into that fee is a hidden trailing commission of about one per cent that the mutual fund company gives to the advisor.
“That means a bond fund with a 2.4 per cent annual fee will need to generate a return of 7.4 per cent to give the investor a five per cent return.
In contrast, advisors who access bonds directly are normally not compensated by the investor.”
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