Bonds’ new adventure

If your recent losses have led you to believe that bonds and other fixed-income investments are a safe alternative to risky stocks, you are making a big mistake. With few exceptions, fixed-income investments are now a lacklustre proposition. In fact, the “fixed income” label that is stuck on thousands of mutual funds has become a misnomer, because most such funds are delivering next to no income these days.

Government bonds offer a particularly nasty example. Since investors have fled in droves to the safety of these bonds, they have become so overpriced that there is hardly any room left for further gains.

Nowadays, to make any money in bonds, you have to choose riskier propositions. Let me show you why by examining the range of fixed-income investments.

The safest end of the fixed-end spectrum has traditionally been money market funds. These funds hold safe short-term debt, such as treasury bills that mature within 90 days. They aim to deliver a steady stream of income that is better than a bank account but not as good as bonds.

Problem is, money market funds are delivering next to no return these days because central banks have cut short-term interest rates close to zero. Returns are so puny that many money market funds would be losing money if their sponsors deducted their usual management fees. These funds are still afloat only because sponsors have temporarily waived fees.

The story is not much better as you move along the fixed-income spectrum to short-term bond funds. The core holdings of these funds are three- to five-year bonds. The returns from those bonds range between 1% and 1.7%. Again, once you deduct fees and expenses, the amount of residual interest available to investors is negligible.

So how about diversified bond funds? These funds hold a broad mix of bonds with maturities ranging from one to 30 years. A typical mix of such bonds is currently producing a yield of 4% or so. But don’t forget that most actively managed bond funds charge a management fee of at least a percentage point. Therefore, you are left with a yield of only 3% or so.

A 3% yield is a paltry return on your investment — and to earn it, you have to be prepared to face another risk. It’s called inflation. Governments are spending massive amounts to stimulate the economy and bail out a broken financial system. Going forward, the fiscal burden of caring for retiring baby boomers will only add to the budget pressures on legislators. The simple, easy way for governments to finance all their obligations is for them to print money and encourage an outburst of inflation.

Inflation is the mortal enemy of bonds because it erodes the purchasing power of your investment. Unlike a stock, most bonds aren’t going to raise their payments to compensate you for inflation. If you buy a 10-year bond, and inflation averages 5% during that period, the purchasing power of your investment falls by 5% each year. Sure, you may be earning 3% interest on your bond, and that interest will compensate for some of your loss, but even with interest included, you lose 2% of your purchasing power each year.

Given the inflationary outlook for the next few years, I think the best alternative for cautious bond investors is real-return bonds. These are bonds, mostly issued by governments, that are indexed to inflation. If you buy one, you collect an average yield of 2% a year, less management expenses, on top of the inflation rate.

Not many funds specialize in real-return bonds and these funds tend to charge expensive fees for what you get. I think the best way for most people to invest in real-return bonds is to buy a low-cost index fund that simply tracks the real-return market at minimal expense. A good choice is the iShares Canadian Real Return Bond Index Fund (TSX:XRB, MER:0.35%).

If you’re willing to take on more risk, you may want to look at corporate bond funds. But be aware of the dangers. Unlike government bonds, which are nearly certain to pay back your money, corporate bonds may stiff you. If a company falls on tough times, management can stop making bond payments and you’re out of luck.

To help investors assess the risk of default, corporate bonds are rated in terms of their ability to repay their debt. Bonds issued by companies with strong balance sheets and cash flows are dubbed “investment grade.” Those issued by weaker companies are “junk” bonds. Lower-rated companies pay a higher interest rate on their junk bonds to compensate investors for the higher risk that they will default.

At the height of the credit crisis this past year, people lost faith in the ability of even investment-grade corporations to repay debts. Investors stampeded out of corporate bonds and the average yield on investment-grade corporate bonds jumped to 7%. Over the past couple of months, buyers have calmed down and started to return to the market, but you can still earn a 5% to 6% yield on a corporate bond fund.

I think corporate bond funds are an attractive investment, but only if you’re comfortable with moderate risk. Investment-grade corporations have defaulted in the past. Still, an averageportfolio yield of 5% should be more than adequate to absorb several potential losses.

Aggressive risk-takers may want to go even further. High-yield bond funds are yielding a mouth-watering 13% as I write this. But beware. During recessions, it’s common for 10% or more of junk bonds to default. Junk bonds are sporting huge yields these days precisely because investors fear many of them will default. Buyers demand a higher yield to compensate them for the high probability that some of these bonds will simply stop paying.

That said, I believe that current yields are high enough to absorb the likely losses. When a junk bond defaults, you usually recover some of the principal. I estimate that a default rate of 25% would be required before you would actually start losing money. Such a level of defaults is unlikely.

In good company on page 8 lists six Canadian corporate bond funds with reasonable management fees and the best risk-adjusted returns relative to their peers over the past three years. I have estimated the average portfolio yield for each fund based on their most recent income distributions. Those yields range from 5% to 10% (net of expenses). The funds with lower yields put a higher emphasis on lower-risk bonds, and vice-versa. You should choose the fund that best suits your risk tolerance.

In good company

These corporate bond funds have achieved better risk-adjusted returns over the past three years than their peers.