When bond funds make sense

Stability and predictability in a volatile market

When managed sensibly, bond funds can help your portfolio in ways that other investments cannot. Learn how the stability of bond funds can fit into your investment strategy.

In the investment world, bonds are renowned for being a stable and steady bet. They deliver regular income with little fanfare. While equities grab the headlines, bonds are hardly noticed, that is until markets get rocky. Then, their ability to play defense and preserve capital captures all the attention.

Investment in bond focused mutual funds has long been favoured by investors seeking steady cash flow at low risk or a safe haven from economic weakness and recession as bond prices move in the opposite direction of interest rates.ᶲ

Bond fund performance

While they can't often match the upside potential of equities, investing in bond funds comes with far more predictability. Bond funds tend to have a weak or negative correlation with growth-oriented mutual funds that include stocks or real estate, making them a valuable counterweight in an investment portfolio.

Finding the right balance

Just how much bond fund exposure should you have? As with other asset categories you hold like equity based mutual funds and cash, how much of your portfolio you want represented by bond funds will depend on your investment time frame, risk tolerance and objectives.

As you get older, you're more likely to seek out regular income from a stable investment so bond funds are a natural choice. But relying too heavily on bond funds can be a mistake even as you age. With more retirees living into their 80s, 90s and beyond, nest eggs will need to last longer than in the past. Continuing to hold growth-oriented investments in your later years can be a key strategy to protecting your income and capital from inflation over time.

Once your ideal fixed income allocation is set, regular rebalancing will ensure your investment portfolio remains properly diversified.

Duration: predicting what happens when rates move

Duration helps you estimate how much the value of a bond will change in response to a 1% move in interest rates. For example, say rates rise 1%. A bond portfolio with an average duration of five years would be expected to lose about 5% of its value. A bond fund with a duration of ten years would likely see a 10% price drop. The longer the duration of a bond fund, the more sensitive it is to interest rate changes, up or down. So if you're nervous about rates going up, lean toward shorter-term bond funds which will be less affected.

Charging up your income portfolio

Before low yields have you exiting bond funds, here are five ways to boost the performance of your income investments.

1. Add corporate bond mutual funds

As with equities-based mutual funds, not all bond funds are identical. Generally, government bond funds have the lowest risk, but that safety comes at a price: potentially low returns.

One way to perk up your portfolio is by adding corporate bond funds. If you invest in a broadly-based bond mutual fund it will likely hold some corporate bonds. Because they're riskier than government issues, corporate bonds offer higher return potential. With high-quality, "investment-grade" bonds from established enterprises like the big banks or the major telecoms and utilities, that additional risk is minimal.

2. Look at the high-yield market – carefully

If you're comfortable reaching out further on the risk spectrum, investing in high-yield bond funds with still-higher return potential is an option. High yield bond funds hold bonds issued by companies that lack the credit worthiness to earn investment-grade status; these bond funds offer better yields to compensate investors for the higher risk involved. High-yield bond fund returns become tied to uncertainty around company fortunes as much as to interest rates.

Consequently, these funds wind up acting more like equity funds when there's market turmoil, making them poor diversifiers of capital risk.

3. Consider real return bond mutual funds

The values of bond investments and their interest payments are generally at risk to inflation, but real return bond funds are an exception. These bonds protect investors from inflation by linking both principal and interest to the consumer price index. This means that real return bond performance tracks the rate of inflation.

Because real return bond funds hold real return bonds, they also carry inflation-risk protection, and tend to be less volatile than traditional long-term bond funds. However, it also means that real return bond funds typically have more modest growth potential than regular bond funds. And, like any mutual fund, they can go down in value.

4. Use tax shelters

Bond interest is taxed at the highest marginal rate, so holding bond investments in a tax shelter like an RRSP or TFSA can help you keep more of those earnings. Should rates fall further any capital gains created will also be sheltered.

5. Diversify into dividend focused mutual funds

Mutual funds that focus on dividend-paying stocks, including preferred shares and REITs, can be important income options to charge up your cash flow.

Unlike bond payments which are fixed, dividends can be raised regularly, helping hedge your income against inflation. Factor in tax-savings through the Dividend Tax Credit and diversifying your income to include dividend paying mutual funds can be a smart play in a low interest rate environment.

Why dividend-paying mutual funds can't replace bonds funds

Despite their attraction as an income alternative, choosing mutual funds focused on dividend-paying holdings doesn't mean you should forget about bond funds entirely. The risk profile of dividend funds closely resembles the broader equity market, not bond funds. Dividend-paying mutual funds may be a good choice to help you generate income, but don't expect them to do much to reduce volatility in your portfolio.

The bottom line

No matter where interest rates are, bond funds can play an essential role in providing regular income while helping steady a portfolio, especially when uncertainty strikes financial markets. But with capital gains less likely and interest rates possibly remaining low, it's important to set realistic expectations for what your bond portfolio can do.

An advisor at BlueShore can help you get the most out of your bond asset class and explore options to take your income further. Contact us today to learn more.