Which Way is Best to Invest in Real Return Bonds - Direct, ETF or Mutual Fund?

In our last post, we examined how real return or inflation-protected bonds can be a boon to retired investors looking for a steady income using a ladder (a series of bonds with staggered years to maturity) of five Government of Canada bonds. But we did not compare the ladder with the two other vehicles available to online investors to do so - ETFs and mutual funds. This post looks at the advantages and disadvantages of the three choices.

The Range of Choices
Real Return Bonds - The most readily available and the most secure bonds are those of the Canadian federal government, issued in five separate series, all maturing on December 1st of years spaced 5 years apart and paying semi-annual interest June 1st and December 1st:

• 2021 maturity - 4.25% coupon (see previous blog post for difference between yield and coupon rate)
  
• 2026 - 4.25%
• 2031 - 4.0%
• 2036 - 3.0%
• 2041 - 2.0%

As well, there are a handful of bonds issued by the Provinces of Quebec, Ontario and Manitoba. All are dated December 1st and make semi-annual payments June 1st and December 1st. Due to slightly higher risk, they provide slightly higher yield.

• Quebec: 2013 - 3.3%; 2021 - 4.5%, 2026 - 4.5%
• Ontario: 2036 - 2.0%
• Manitoba: 2013 - 1.753%, 2018 - 1.738%

ETFs - There are only two in Canada, one announced by BMO Financial Group only this past week.

• iShares DEX Real Return Bond Index Fund ( symbol: XRB) - launched in 2005
• BMO Real Return Bond Index (ZRR)

Mutual Funds - A search using GlobeFund (in the Fund Filter, under Asset Class, scroll down and choose Canadian Inflation Protected Fixed Income) brings up 19 funds, including the two ETFs. Several companies have multiple classes of units to buy depending on whether advisors are involved (usually F class) or direct arrangements are made for very large purchases (like SEI O class). Ignore them. For individual investors doing their own investing online, it is the A or D class funds to buy. That means 10 real return funds to choose from.

How the Choices Stack Up - Pros and Cons
The comparison table below sets out the characteristics of each choice, which we assess as follows. The chart highlights in green the points where one choice seems to be superior. But be careful, the amount of green doesn't necessarily add up and indicate the best choice overall. Read on to find why and then make up your own mind.


MER (Management Expense Ratio) and Net Investor Return - The annual deduction of fees by the ETF or mutual fund company is a critical factor. Why? The MER means a direct reduction in the net return for the investor. The lower MER, the better. When you buy RRBs directly, there is a one-time commission of around 1% embedded in the price charged by the broker selling you the bond, but when spread over the life of a 20 or 30 year bond, the cost per year can be tiny.

Particularly for RRBs, where the total universe of bonds is very limited and there is not a great deal of trading to do in a fund to rebalance or track an index, a buy-and-hold-to-maturity investor, like the retiree in our previous post, gains an appreciable net return advantage from buying bonds directly. MER is especially significant nowadays when RRB yields are 1.5% or less. Funds with MERs above that will produce a net loss for the investor. (The only way that could be countered is through a rise in RRB prices. How likely is it that bond prices will rise further, aka real yields will fall further, from their current all-time low levels?)

Against the big return advantage of direct purchases must be weighed the various other factors, some of which might be important enough for an investor.

Availability to Buy - Some days you might call your broker to find that there is no inventory of certain bonds or maturities available to buy. It might take some days or weeks to fill out a ladder of bonds. By contrast, the fund companies all have the ladder in place and you just need to buy shares or units at any time on any day.

Purchase Commission / Loads - Direct bond purchases incur a 1% or so commission embedded in the bond price. ETFs incur a trading commission which becomes cheaper in percentage terms the bigger the purchase. Mutual funds may have an upfront load fee, though the PH&N Inflation-Linked Fund highlighted in the chart has no fee.

Interest Income Frequency - Though all the RRBs within funds pay out interest only semi-annually, some of the funds distribute cash more often on a quarterly basis. These more frequent cash flows may be helpful to some people to match their income flow with their spending.

Interest Income Predictability - Directly purchased bonds will give off a highly predictable income stream that will rise steadily with CPI inflation. Fund cash distributions per share or unit will vary, sometimes considerably, due to the buying and selling within funds that changes the portfolio composition. For instance, iShares XRB cash distributions went up 21% from Q2 to Q4 in 2008 and then back down 24% in Q2 2009. That kind of bouncing around ill serves the retired investor seeking a stable income stream with predictable purchasing power. Funds compare poorly to direct purchases on this factor.

Drawdown Capital for Income - The ability to take out part of the capital invested, as opposed to receiving only the interest income, may be significant to some retirees. Having to sell off portions of directly held bonds becomes quite expensive due to recurring commissions and requires time and effort to plan. In addition, the balance of the ladder will be disrupted. By contrast, mutual funds routinely set up so-called systematic withdrawal plans for investors to take out regular payments at no extra cost. ETFs sit in the middle, with trading commissions and no automatic withdrawal plan, but the withdrawal through selling some shares can be of any size desired and the bond portfolio balance never gets out of whack.

Interest Distribution Reinvestment - For those who do not need to spend the interest income and want it reinvested in more bonds, mutual funds easily and routinely will reinvest the interest at no extra cost. Our two ETFs differ - the new ZRR fund will reinvest interest for the investor if desired but with XRB there is no automatic plan to do that and the only way to reinvest is to buy more shares on the market, which probably will work out to a fairly high percentage cost of reinvesting (e.g. a $10 commission to reinvest $500 of interest is a 2% cost).

Diversification - Since default risk with Canadian government and most provincial government bonds is pretty low, the main reason for holding a variety of RRBs is to mitigate the risk that interest rates will shift unfavourably at the time when a particular bond issue matures and that consequently reinvestment must take place on poor terms. This may not even be a concern at all if a retired investor intends to spend the capital when a bond matures. All the various fund versions provide the best available diversification through a variety of staggered bond maturity dates using the limited number of bonds on the market.

Purchase Minimum - This factor would most likely interest those pre-retirement investors who are at the early stages of building a portfolio and want to make small or regular purchases, as opposed to a retired investor wishing to build an appreciable income stream through large lump sum purchases. As we showed in the previous blog, it takes a hefty total to buy enough RRBs for significant income, such that even a minimum purchase size of $5000 would not be an impediment.

Reinvestment at Maturity - When a bond matures, a person holding a bond directly must then buy a new bond to stay invested, a bit of work and subject to interest rate risk as described above. With any of the funds, there is nothing the investor need do as the fund handles reinvestments and the fund itself never matures.

Portfolio Rebalancing - One of the basic principles of investing is to set target allocations for each asset class (see previous Asset Allocation post). This should include RRBs within fixed income. With direct bond holdings, this process would be awkward and imprecise due to the necessity to buy or sell bonds in multiples of $1000 face value along with having to choose which bond to buy or sell. The 1% commissions also add to costs. With funds, the amount bought or sold can be exact at no (mutual funds) or low (ETF) cost and the bond mix remains unchanged because it is always within the fund. For a retired investor seeking dependable known cash flow, the asset allocation target may take a back seat so this factor may not be too important.

My Bottom Line View:

• Direct bond purchases are best for retirees or others seeking the highest return and most stable income cash flow
• BMO's new ETF (ZRR) offers a credible alternative with its low MER and automatic free distribution reinvestment for investors building up a portfolio who can make large enough purchases to minimize trading costs
• Mutual funds like PH&N's with reasonably low MER and automatic everything may suit for investors needing to progressively withdraw capital or for those wanting to make small regular purchases to build a portfolio
  

Hopefully, the above look into the details of the options for buying real return bonds provides enough practical information for you the investor to choose the best option for your circumstances.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.