For bond products, it's the price, stupid
Jonathan Chevreau The National Post December 2, 2000
For bond products, it's the price, stupid

Exchange-traded funds (ETFs) are quickly becoming a compelling alternative to equity mutual funds for cost-conscious Canadian investors.

But, until very recently, it was tough for investors to find an alternative to outrageously overpriced bond mutual funds. The average Canadian bond mutual fund sports an egregious 1.7% management expense ratio (MER), according to University of Toronto finance professor Eric Kirzner.

Now that bond ETFs are available in Canada with MERs of about 0.25%, you have to wonder why anyone with access to a stock broker would invest more than small amounts -- if anything -- in high-MER bond mutual funds. The bond ETFs have lower MERs than even the cheapest bond funds and index bond funds. And they appeal to cost-conscious

As was the case with stock ETFs, bond ETFs are being pioneered in Canada ahead of the rest of the world. Trading commenced last week on the Toronto Stock Exchange in two new products from the Canadian unit of one of the world's ETF pioneers: Barclays Global Investors.

The official names of the new Barclays bond ETFs are iUnits Government of Canada 5-Year Bond Fund (the iG5 Fund) and the iUnits Government of Canada 10-Year Bond Fund (the iG10 Fund).

Bond ETFs give small investors access to "wholesale" bond pricing. While it's a no-brainer to pick these funds over the average bond mutual fund, the price advantage is less obvious against setting up "ladders" of either government bonds or strip bonds. (Ladders are portfolios of bonds of different durations, set up so some mature each year.)

Direct cost comparisons are difficult because of the lack of transparency in bond pricing, says a do-it-yourself investor who posts on the Wealth forum at www.theboomer.com as "Shakespeare."

The bond ETFs distribute interest income twice a year. They can be bought or sold on the TSE at any time throughout the day, allowing investors to "lock in" a five-year or 10-year maturity with a single trade.

The ETFs own single Canada bond issues at any given time. When Barclays picks a new Canada bond, the funds sell all their existing holdings and purchase the new bonds.

That provides investors with a relatively constant risk profile, Shakespeare says. A bond held to maturity has less risk as it matures. He calculates that an investor wishing to approximate the risk profile of a five-year bond ETF would need a bond ladder that is longer -- perhaps nine or 10 years -- and constantly renewed.

A bond ETF can be bought for less than a strip bond and in the current interest rate environment, the five-year Barclays bond ETF should have a higher return than a five-year ladder, he says.

Still, investors need to consider the respective cost of paying their broker to buy or sell these competing products.

Most investors need between $50,000 and $100,000 available to establish a good bond ladder, but you can buy bond ETFs in much lower amounts. However, as with stocks, investors must factor in minimum brokerage commissions.

While commissions vary between full-service, discount and hybrid brokers, expect to pay a purchase commission of 0.28% to acquire a bond ETF.

If you intend to live off the interest income only, then there's only one brokerage fee when you establish the ETF position, says Bylo Selhi, a do-it-yourself investor advocate.

Those in the wealth accumulation phase will likely invest new money at regular intervals and reinvest interest every six months. Those investors may want to first accumulate in a bond fund, then convert it into an ETF once a year or so, so as to minimize minimum brokerage commissions.

Those who plan to ultimately sell the bond need to factor in another 0.28% on the eventual sale commission, along with a bid-ask spread of roughly 0.2%, Shakespeare says. The cost of a round trip (buy, then sell later) on a bond ETF executed at a discount broker is therefore 0.76%, or about half the 1.5% to set up a bond ladder.

For low amounts (below $1,000, say), investors may be better off with such traditional alternatives as bond mutual fundsor Canada Savings Bonds, given the minimum brokerage fees.

At higher amounts, $5,000 or $10,000 investments at a time, it seems almost a dead heat between bond ETFs and bond ladders.

If you have already established a bond ladder, you should not sell it, because the ladder has an effective MER of 0.28% and you will incur a penalty of 1.5% to sell your bonds.

However, investors with maturing bonds should consider reinvesting the proceeds in iG5s or iG10s. Shakespeare concludes the bond ETFs beat bond ladders if the investor doesn't need periodic access to capital.

But investors also need to consider liquidity, Bylo Selhi adds: "That's why I have some CSBs and Ontario Savings Bonds for liquidity even though the bulk of my fixed is in bond funds. While bond funds are volatile, the swings are usually smaller than with equities. And bond ETFs are a good choice for many investors."

 

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