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Three ways to buy bonds

What is the best way to buy bonds? There is no perfect answer to this question.  The ultimate answer, like most questions in the investment industry, depends on the individual needs and circumstances of the investor.  Let’s walk through some different ways to buy bonds and the pros and cons of each.

Buying a bond fund

Bond funds give investors the ability to buy an instantly diversified portfolio of bonds.  A bond fund will consist of many different bonds with different terms, types, durations and yields.  They are easy to access as their minimums are low. They are also easy to sell since they are valued on a daily basis.

The biggest criticism of bond funds is that in many cases the management fees are too high.  The average management expense ratio (MER) for Canadian bond funds in 2011 is about 1.7%.  This has remained fairly constant from 2001 when the average MER for Canadian Bonds was also 1.7%.  Remember that this is the average MER.  Bond fund MERs range from a low of 0.10% to a high of 3.43%.

With bond funds, it has been proven that fees do make a difference but they are not the only determinant of value.  If you buy a bond fund, shop wisely because they are not all the same.  Look for bond funds with lower MERs.

The professional managers of these funds will tell you that a bond fund will give you a more sophisticated approach to buying bonds.  They argue that they can employ management strategies that the average investors cannot do themselves like active bond trading, managing bond duration, and having access to different types of bonds.  I heard Bond Fund managers argue they can also buy bonds at a better rate simply because of volume.

Buy your own bonds

Critics of bond funds argue that you can create your own diversified bond portfolio by buying individual bonds.  Many do it yourself investors feel that buying bonds is not as sophisticated as these bond fund managers make it out to be. They believe that most bond funds are simply an over-diversified ladder of bonds bought and held to maturity, and that the amount of work to ladder a portfolio of bonds does not justify paying 2% in MERs.

The bottom line is that you can save yourself a lot of money if you have the time, energy, resources and knowledge to buy a ladder of bonds and manage it yourself.  Some suggest that to build a diversified bond ladder, you need a minimum of about $25,000.  There’s no hard and fast rule but given minimums and the amount needed to properly diversify a portfolio, $25,000 is a good starting point.

Certainly buying individual bonds is an option but many people may not have the knowledge, desire or ability to research individual bonds properly.

Buying Bond Exchange Traded Funds

The third way of buying bonds is through Exchange Traded Funds (ETF).  Bond ETFs have become very popular.  According an article by Personal Finance Columnist Rob Carrick, Bond ETFs account for 25% of the $42billion invested in ETFs in Canada.

A bond ETF is like a mutual fund in that it has a diversified portfolio of bonds but it trades more like a stock than a mutual fund.  In most cases, the Bond ETF fees are very low compared to mutual funds because the performance mimics a bond index.

There are many different options but here are three excellent choices as core bond holdings:

My five cents

In my portfolio, I have never bought bonds directly or set up a bond ladder.  Instead, I have been a GIC rate shopper and have found that returns of GICs are similar to government bond rates but without the volatility.  Obviously, when bond returns are pushed up because of falling interest rates, GICs to not experience that same upside.  That being said, GICs never drop in value so a GIC ladder gives some peace of mind.

In my RRSP portfolio, I have primarily used bond funds in the past but now, I much prefer the lower fees from Bond ETFs.  This is really important since my research on fees suggest that lower fees is more important when it comes to bonds and fixed income investing.

How do you prefer to buy bonds?  Do you have a different approach altogether?

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

8 Responses to Three ways to buy bonds

  1. I used to buy bonds for my RRSP accounts, but when it became impossible to find government bonds, strips or zeros that paid as much as GICs, I switched to a 5 year ladder of CIDC-insured GICs.

    Can’t beat that guarantee. I still have some of my long-term bonds, but I don’t see the benefit of buying bonds now (I never sell them – I just hold).

    Since interest rates must (eventually) go up, I don’t see why anyone would buy bond funds or ETFs now.

    Don’t forget that GICs issued by credit unions are not covered by CIDC.

    • Thanks for sharing Wendi1. GICs from Credit Unions are not covered under CDIC but they are covered through Credit Union Depositor Protection Program (CUDPP).

  2. I attended a seminar many years ago where bonds were discussed by a banking representative. I took away from that seminar that up to 80+ percent of a hi-grade bond portfolio could be bought and held on margin. Can anyone comment?

  3. Great advice Jim.In these troubled times a Canadian government guarantee beats paying a 1.7% MER on a bond fund or even a .20% MER on a bond ETF when the value of the bonds are going to drop when interest rates inevitably rise.At least with GIC`S you get your principal and compounded interest back on GIC maturity.In an RRSP your interest rate on a GIC only has to keep pace with inflation and not taxes as well- an impossibility
    in a low interest rate enviroment -regardless of what fixed income rate product you purchase.

  4. I only buy bond mutual funds. Frankly, the main reason is because I’m not very educated on the alternatives. I have a ROTH, and I just look at what’s available within the fund family I use for investing.

  5. Bonds should be part of any portfolio, but stay with Corporates that have a five year window.
    Interest Income is taxed at 100% so if income is the reason for buying, stay with the Pfizers and similar that pay a good dividend, give yo better tax treatment and also exposure to US $.
    Buy about 10% JNK and about 10% Bonds from an ETF in emerging markets, plus about 10% XTR.
    buying Bonds in Canada is very difficult, but RBC is light years ahead of others in giving you choices.
    I treat bonds like owning a building, i don’t care about daily values, I just want the rent, and will sell at maturity.
    A portfolio for my estate has zero bonds, except JNK, a 20 year horizon, I can wait out fluctuations.

  6. I also use to buy savings bonds for my kids, nieces, and nephews when they were younger. I haven’t tried buying them electronically yet, but it does seem a little bit like you’re buying nothing now that you don’t get that official piece of paper.

  7. When I retired in 2001, 30 yr bonds were paying 10% but I thought I could do better lol. I didn’t 🙁

    There are still some good Long term provincials today at 5.7%, mostly BC bonds 30+ years.

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