Not the pristine, risk-free investments you thought they were
As RRSP season rapidly draws to a close (the deadline for contributions eligible for a 2013 tax deduction is March 3), I’ve been fielding plenty of questions about investments for an RRSP. One that frequently pops up is whether a bond fund would be suitable. After all, the argument goes, they’re bond funds, so they must be safe, and they have a better yield than GICs, for example. The reality is a bit different and bit more complex.
Bond funds, both mutual funds and exchange-traded funds (ETFs), are the classic defensive investment class in a diversified portfolio that might also include exposure to growth assets like equities. But bond funds are far from the pristine, volatility-free investments that novice investors often imagine them to be. That’s because bonds are directly impacted by the prevailing level of interest rates, and even more importantly, the expected level of interest rates. And here’s where things get complicated for investors.
Rate impact impossible to forecast
It’s impossible to forecast precisely how “future” increases in rates – or any other macro-economic factors – are likely to affect the performance of any type of asset class, whether it’s fixed-income or equity. However, there are certain guidelines you may be able to use when analyzing your investment choices in fixed-income funds.
The first, and most important, characteristic of fixed-income investments to remember is that as the prevailing level of interest rates rises, the prices of bonds (and other fixed-income or fixed-income-type assets) declines. This has to do with the relationship between a bond’s price and its stated “coupon rate.” Bonds are priced on the open market so that their “yield” (basically, a bond’s stated coupon rate divided by its current price) remains competitive with yields of instruments of comparable quality and term. So (to take a very simplified example), if high-yield corporate bonds are currently yielding 4%, a bond with a stated coupon rate of, say, 3.5%, would be priced around $89 per $100 of face value, a discount of $11 from par, so that it yields about 4%.
As bond yields rise…prices fall
The problem for bondholders here is obvious. When rates rise, bond prices decline, shrinking the value of bond holdings in a portfolio. And this is precisely the problem bond funds have been wrestling with recently. Prevailing interest rates have been so low for so long that, as economic growth improves (especially in the U.S.), the next move will almost certainly be higher. Already the U.S. Federal Reserve Board has “tapered” its monthly program of Treasury bond purchases (quantitative easing), and markets are likely to see this as the first step towards an eventual hike in rates.
Bond fund managers have a number of techniques they use to deal with the uncertainties of interest rate movements. They may, for example, adjust the average term to maturity of their portfolio (shorter-term bonds tend to be less volatile than longer-term issues). They may adjust something called “duration” (a measure of how many years it would take to repay the price of a bond from internal cash flow) – the higher the duration, the greater the risk. In high yield funds, which tend to hold corporate bonds, they could also tinker with quality, defensively increasing the number of BBB-rated bonds, for example, while reducing the number of lower-rated issues and increasing cash.
It’s also helpful to look at some of the performance and risk measures for mutual funds before you make a decision. At a minimum, investigate the fund’s standard deviation, a common measure of a fund’s variability of return from its long-term average. The higher the standard deviation, the more volatile, or riskier, the fund is.
Another good clue to the quality of the fund, and thus a place to begin your research, is with the Fundata FundGrade® ranking. This is an entirely objective monthly quantitative measurement developed by Fundata Canada Inc. that ranks investment funds from a top grade of “A” to a low grade of “E.” I like the FundGrade rating, which also rates ETFs, because there’s no confusion about what it is. The analytic brains at Fundata have stripped out any subjective element in the calculation (for example, there is no subjective assessment for a specific manager’s “value added” and the like). Basically, what you get is an honest one-letter answer to the question: “Did this fund deliver?”
Note that what I’ve described here should comprise only the beginnings of your research into bond ETFs and mutual funds as potential investment candidates. To properly place such investments into your RRSP in the context of your overall portfolio, it’s always best to consult with your investment advisor or financial planner.
© 2014 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.