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Bonds and Bond Mutual Funds Versus GICs – Consider the Risks

Many people buy bonds or bond mutual funds because they need the safety of fixed income investments in their portfolio. Please note that I am not talking about Canada Savings Bonds.  Their name is a bit misleading as they differ from traditional bonds issued by governments and larger corporations.

Bonds are traded on a daily basis in bond markets, and they will change in price/value based on interest rates fluctuations. If you hold a bond until it matures, your principal will be safe unless the government or corporation is unable to pay you.  However, if you sell a bond before its due date, you can lose some of your principal or receive a capital gain because of changes in value.  With a GIC, you cannot sell it until the maturity date and the value does not fluctuate.  You will be paid the principal and interest for your GIC as long as the financial institution is able to pay you, which is the same as holding a bond until it matures.  If interest rates go up (or down) during the GIC term, you will be locked in to that rate until it matures.   If you are dealing with a chartered bank, the Canada Deposit Insurance Corporation should cover your first $100,000 in the event of a bank failure.  Credit unions and insurance companies have similar insurance programs.

The value of a bond goes up and down based on changes in interest rates.  I can explain the reasons, but I believe this article – Time to Get Out of Bonds by  Jason Heath, November 4, 2014, on the MoneySense web site does an excellent job.  You should read it now.  When your financial planner recommends bonds or a bond mutual fund as a safety net for your investment portfolio, consider the issues raised in the MoneySense article. Also, compare the risks versus potential earnings to those of guaranteed investment certificates.

A bond mutual fund is priced based on the value of its bonds, priced on a daily basis.  Even if a mutual fund holds its bonds until maturity, you will still have a gain or loss when you sell your fund because of these daily valuation changes.  The daily value of the mutual fund will not only be equal to the principal invested plus the accrued interest, but also the gains and losses on that day, even though may never materialize in the future if the bonds are held to maturity.  Since you are selling on that particular day, you will have a gain or loss.

Also, ensure you compare apples to apples when looking at rates of return.  Your GIC rate is quoted as a future rate – you know what you will be paid.  Bond fund returns are often quoted on a historical basis, which may not be repeated.  The yields on individual bonds can be quoted, but the fluctuation in bond value is unknown should the bond be sold before it is due.  Bond funds frequently sell bonds before maturity.

Assume the average yield on the bonds in a bond fund is 2.5%.  If the value of the bonds increases or decreases by 1%, your overall rate of return will be 3.5% or 1.5%, respectively.  This is before subtracting the fees paid to the bond fund to determine your final rate of return.  What is the interest rate yield of the individual bond (or average of the bonds held within the bond fund)?  What are the fees you are paying in the investment account on the bond portfolio?  If a bond is paying 2% interest, and your fees are 1.5%, you are only making 0.5% yield, which is then increased for any capital gains or decreased for any capital losses if sold before maturity.  Ultimately, what is left over for you?  (Do this same calculation for the bond portion of a balanced mutual fund – if the bonds are paying 2% interest, and your fees are 2% or higher, you need to have a capital gain on the bonds to make any money from them.  See my article regarding My Issues with Balanced Funds.

You cannot compare future rates of a GIC with historical performance of a bond fund to make a good decision.  Remember that bond returns decline as interest rates are rising, and increase when interest rates are falling.  For most of the past thirty years, interest rates have been falling, providing good returns for bonds.  Which way will they go in the future?  You can make your own decision, but understand the potential gains in comparison to the possible risks.

Demand for bonds can change for other reasons, such as the safety of Canadian bonds versus other nation’s bonds, or the risk of default on corporate bonds versus the risk of default by a government.  Such factors may increase or decrease bond values.

If you are dealing with a professional financial planner (i.e. qualified with appropriate credentials and a code of ethics), you should be given objective advice.  However, if you are dealing with an unprofessional advisor, keep in mind that commissions they receive to sell a bond fund are higher than those for selling a GIC.  Are you getting the best advice?

Certainly, bonds are safer than shares of companies bought on the stock market, but they are not without risk. And you should compare bonds to GICs, including the fees charged when looking for safe investments.

Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum