If you need steady income and want to hold bond funds, we advise you to focus on those with short-term maturity dates (see below for more on bond funds). That’s because bonds with shorter terms face a lower risk from interest-rate increases. You should also avoid funds that take part in any kind of speculative trading.

Low fees, high-quality holdings are pluses for this bond ETF

The iShares DEX Short Term Bond Index Fund (symbol XSB on Toronto) is a bond exchange-traded fund (ETF) that we cover in our Canadian Wealth Advisor newsletter. The fund cuts risk by avoiding speculative trading and emphasizing government bonds.

The fund mirrors the performance of the DEX Short Term Bond Index. This index consists of a wide range of investment-grade federal, provincial, municipal and corporate bonds with between one- and five-year terms to maturity. The iShares Canadian Short Term Bond Index Fund currently holds 201 bonds with an average term to maturity of 2.92 years.

Top issuers include Canada Housing Trust, the Government of Canada and the Province of Ontario. The bonds in the index are 72.1% government and 27.9% corporate.

The iShares Canadian Short Term Bond Index Fund has expenses of just 0.25% of assets per year.

The fund yields 3.37%. However, this high yield is due to the fact that some of the fund’s bonds pay above-market interest rates. But as a result, they trade above their face value. When these bonds mature, holders will only get the bonds’ face value, which means the portfolio will incur predictable capital losses. These losses will offset some of the appeal of the above-market yields.

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The key figure when looking at the long-term return of this fund is yield to maturity. This yield takes into account the series of capital losses the fund will experience as its above-market-rate bonds mature. iShares DEX Short Term Bond Index Fund’s yield to maturity is around 1.99% — less than the 3.37% yield, but still higher than the 1.29% you’d earn by investing in, say, a one-year T-bill.

Low interest rates hurt the long-term potential of bond funds

The performance of bonds is inversely related to the rise and fall of interest rates; when rates fall, bond prices go up. The opposite is true when rates rise.

With interest rates near historic lows, bond funds that hold long-term bonds simply can’t go a lot higher than they are today. In fact, it seems more likely that interest rates will continue to hold steady or rise slightly in the short term, and move higher in the long run. This means the funds would only earn interest income on their bonds; instead of capital gains, their bond holdings could produce capital losses.

That’s why we avoid bonds — and bond funds — when we manage portfolios of clients of our Successful Investor Wealth Management service.

Most bond funds’ MERs are too high in light of their low yields

Another problem with bond mutual funds is their high management expense ratios (MERs) in relation to their potential returns: When bonds yielded 10%, perhaps it made some sense to buy bond funds and pay a yearly MER of, say, 2%. Now that bond yields are generally below 4%, it makes a lot less sense.

As well, the bond market is highly efficient, and few managers can add enough value to offset their management fees. So investing in these funds can expose you to the risk that a manager will gamble in the bond market and lose money.

That’s why, if you want to hold bond funds, we recommend taking the low-MER approach offered by a bond ETF like the iShares DEX Short Term Bond Index Fund.

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