The best bond funds hold short-term bonds and have low fees

Bond funds are ETFs or mutual funds that invest most of their assets in government or corporate bonds.

If you need steady income and want to hold the best bond funds, we advise you to focus on those holding bonds with short-term maturity dates. 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 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 for our Successful Investor Wealth Management clients.

Bond market tips for investors

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

Inflation is another threat to bond funds. If the funds hold their bonds to maturity, they will get back the bonds’ full value—but inflation will have cut the purchasing power of the bond’s face value.

As a general rule, the safest bonds are issued by or guaranteed by the federal government. Next come provincial issues or bonds with provincial guarantees.

Corporate bonds are far riskier than government bonds, although the risk on corporate bonds, varies widely. Some corporates are almost as safe as government bonds and offer only slightly higher yields. Some corporates are far riskier and offer far higher yields.

Beware of buying vaguely described bond mutual funds or ETFs

Get rid of bond mutual funds or ETFs that show wide disparities between their portfolios and the investments that the sales literature describes. Many mutual fund or ETF operators describe their investing style in vague terms.

It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at an ETF’s or mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. When the bond mutual fund or ETF takes on a lot more risk than you’d expect—perhaps by overweighting riskier corporate bonds over government bonds—our advice is to get out.

The best bond funds are seldom mutual funds

Many bond funds built great performance records in the last decade. But this was a function of the trend in interest rates; when rates fall, bond prices go up. Interest rates could move upward as the economy recovers or in response to inflation fears. This is another way of saying that bond prices could fall.

When bonds yielded 10%, perhaps it made some sense to buy bond mutual funds and pay a yearly MER of, say, 2%. Now that bond yields are down closer to 4%, it makes a lot less sense, and has a greater impact on your mutual fund’s performance.

The bond market is highly efficient, and we doubt that any bond mutual fund’s performance can add enough to offset its management fees. In addition, investing in a bond fund exposes you to the risk that the manager will gamble in the bond market and lose money.

Buy bond funds ETF’s to cut your MERs

Bond fund ETFs charge considerably lower MERs than bond mutual funds.

For example, the iShares Canadian Short-Term Bond Index ETF, symbol XSB on Toronto, charges just 0.28%.

That’s why, if you want to find and hold the best bond funds, we recommend taking the low-MER approach offered by a bond ETF.

If you want to invest in a bond fund, the iShares Canadian Short-Term Bond Index Fund is a buy.

Do you own any best bond funds? How have these bond ETFs performed in your portfolio? Share your experience with us in the comments.