Bond funds look good

Last year was a rough one for Canadian bond funds – up until August that is. That’s when investors suddenly woke up to the financial damage being wreaked by the U.S. subprime mortgage crisis and decided to make safety their number priority.

Government bonds, which had languished for over a year as interest rates moved higher, became hot commodities almost overnight. Bond indexes, which had been in the red for most of 2007, began to turn around and move into the black. Investors, who had avoided bond funds because of their weak returns, decided that having a little money there wasn’t such a bad idea after all.

Over the six months to Nov. 30, the average Canadian equity fund lost 2.78 per cent of its value. During the same period, the average Canadian fixed income fund gained 2.44 per cent. Those numbers may come as a shock to many readers but they’re an accurate reflection of what’s been happening in the markets in recent months.

I believe we will see more of the same in the first quarter of 2008. Equity funds will continue to struggle under the twin burdens of huge corporate write-downs and recession fears. Bonds and bond funds, by contrast, will be islands of stability, especially the funds that focus on government issues. Here are two that I especially like:

RBC Canadian Bond Index Fund. This bond fund is a great choice for conservative investors seeking safety, stability, and cash flow. It tracks the performance of the RBC DS Government of Canada Bond Market Index and carries a low MER of 0.7 per cent. This low MER helps to make it a consistent outperformer in its category. In the year to Nov. 30, it gained 3 per cent, compared to only 0.71 per cent for the average Canadian bond fund. Virtually all the advance was fuelled by the heavy demand for government bonds resulting from the subprime mortgage crisis in the U.S. However, this fund is not a short-term wonder. Over the past five years, it generated an average annual compound rate of return of 4.89 per cent, well ahead of the category average. The fund’s assets are top grade – Government of Canada bonds only. Risk is better than average for the bond category and the fund has never lost money over a calendar year. That makes it a good, conservative choice for an RRSP or a RRIF. Distributions are paid quarterly and the 12-month yield to Dec. 21 was 3.67 per cent. It’s a no-load fund and you only need $1,000 for an initial investment. I give it my top $$$$ rating.

iShares CDN Government Bond Index ETF. If you prefer exchange-traded funds over mutual funds, this relatively new iShares entry from Barclays Global Investors Canada is one to consider. It tracks the performance of the DEX Universe All Government Bond Index (formerly the Scotia Capital Index) and has a very low MER of 0.35 per cent. Despite the lower MER, it did not do as well as the RBC fund over the year to Nov. 30, gaining 2.53 per cent. However, that was still well above the category average and over the longer term this one should do better simply because of the MER advantage. As with the RBC fund, distributions are paid quarterly. The fund trades on the TSX under the symbol XGB and closed on Dec. 28 at $20.01. A brokerage commission will be charged.

I like both these funds for low-risk portfolios. Talk to a financial advisor to see if they are appropriate for your needs.