Bonds, money markets: What’s out there?

Zoomer | January 1st, 2006

During times of stock market turbulence, bond and money market funds are considered to be safe havens for investors. The problem is many people don’t know how to use them properly. Here is a run-down of what’s available in the fund market these days.
 
Bond funds:
There was a time when bond funds were simple and no complex decision-making was involved in making a selection. That’s no longer the case. As with equity funds, the range of bond funds offered to investors has expanded dramatically in recent years.

Now you can choose amongst these classifications:

  • Regular bond funds:  These are your standard meat-and-potatoes bond funds, investing in a portfolio of debt securities from different issuers with varying maturities.

  • Short-term bond funds: Regular bond funds are vulnerable to loss during periods when interest rates are rising. Short-term bond funds are less risky because they hold only securities with a term to maturity of less than five years. If rates rise, bonds of this type will be less affected. The price you pay for this increased safety is a lower return and almost no cital gains potential.

  • Mortgage funds: They’re a variation on short-term bond funds except that they invest in residential first mortgages.

  • High-yield bond funds: You’ve heard of junk bonds? This is a nicer way of saying the same thing, and making the managers of these funds feel better about their work. And, truth be told, we don’t have many genuine junk bonds in Canada. They’re more of a U.S. phenomenon.

    • High-yield bonds: These are issued by companies with a lower credit rating. As a result, the interest rate they have to pay to borrow is higher than would be charged to a blue ribbon client like the Government of Canada or a major bank. Of course, such companies are at greater risk of going under, especially in a recession. So if you’re at all risk-averse, you should steer clear of these funds during economic downturns.

  • Foreign bond funds: These funds invest in debt securities issued by foreign governments or companies, or in Canadian bonds denominated in foreign currencies. There are a lot more of those than you think. All levels of government frequently issue U.S. dollar bonds and you can also find issues in Euros, Japanese yen, Swiss francs, sterling and German marks.

    • Funds that specialize in Canadian foreign currency issues are fully eligible for registered plans (the currency isn’t what counts, it’s the issuer). Those that invest offshore are considered to be foreign content for RRSP and RRIF purposes. Foreign bond funds perform best when global interest rates and the value of the Canadian dollar are falling in tandem.

    • Money market funds:  As mutual funds go, this is about as simple as it gets. Money market funds invest in short-term debt securities, normally with maturity dates of less than a year. Unit values are fixed, usually at $10, and do not fluctuate. Cash distributions are made monthly. These funds are very safe and highly liquid, and are a good place to park spare cash.

    There are three types of these funds:

    • Canadian money market funds: These invest in Canadian dollar securities issued by governments and corporations.
    • T-bill funds:  These focus on Government of Canada Treasury bills, so are considered slightly safer than regular money market funds.
    • Foreign money market funds: These invest in securities denominated in other currencies, usually U.S. dollars. Some of these funds are fully eligible for registered plans because they invest in foreign currency notes issued by Canadian governments and corporations.