The Truth About Bond Funds

If what you KNEW to be true about investing in bonds turned out not to be true, when would you want to know?

Bond funds have historically been some of the safest investment options available to Canadian investors.   The great returns we have seen over the past 20 years however, have largely been driven by falling interest rates.    And this has led many investors to believe that bond funds are very safe and stable investments.   It couldn’t be further from the truth.

WHEN INTEREST RATES FALL, BOND PRICES INCREASE.   WHEN INTEREST RATES INCREASE, BOND PRICES FALL.   Bonds, when issued, are issued at current interest rates.   For example, let’s take a look at a Bond that was issued at 7%.   If interest rates fall after that bond is in circulation, you would obviously pay more for a bond earning 7% than one earning 5%.    That is why, since over the past 20 years, as interest rates have declined, bonds and bond funds, and bonds inside balanced funds have had very good performance.

But that’s the past.   What are we looking at today?    We are at all time historically low rates.       So that means not much room for interest rates to fall and give a bond fund a price increase.   But lots of room for bonds to increase and bond funds to fall.  They say that for every 1% interest rate hike, bond funds will drop 12%.   So it’s not as safe and secure as investors think.

And even if rates don’t rise, and there are a lot people in this camp, the average 5 year bond is earning less than 2% so it would be hard pressed to get a return that exceed the average management fee of 2%.       So best case scenario might be you’ll earn nothing and worst case is a loss.  

I don’t like those odds.

As a wealth strategist that puts me in a very difficult position when setting up portfolio for my clients.   Cause most of us have a balanced investor profile.   So there is always some required level of safety and stability in a portfolio.     Where to turn?

Here are my top 3 choices on where to turn for the safe and stable part of your investment portfolio:

Real Estate – For investment portfolios I use the Great West Life Canadian Real Estate Fund for that stable safe part of client’s portfolios.   The portfolio owns commercial real estate and apartment buildings throughout Canada and benefits from rental income as well as the price appreciation of the properties.     It is a great fund to diversify you away from both Canadian Bond Funds as well as the stock market.    Owning Rental Properties is another way to diversify your portfolio.   Even if properties never increase, over the next 20 years you will receive rental cash flow and someone else has paid off the mortgage.   A rental property will give you a nice stable retirement income down the road.     

Mortgage Investments – The problem with Bond Funds is the fluctuation of prices with interest rate movements.   And the problem with Bonds directly or GICs for that matter is the low interest rate.   But mortgage investments can give you a nice 8% return while your principal is secured on title in a mortgage.  

Permanent Whole Life Insurance – I can’t think of anything more stable than a boring whole life policy where the investments grow tax sheltered, values are guaranteed, values can only ever go up (never down), and can provide a tax free retirement income during your lifetime as well as tax free inheritance to your beneficiaries.

Now that you know the truth about investing in bond funds, what are you going to do about it?