Are bonds for income anymore?

Maybe not, but they haven't outlived their usefulness.

Christopher Davis 16 May, 2016 | 5:00PM

Note: This article is part of Morningstar's May 2016 Income Investing Week special report.

If they ever won a million dollars, my grandparents said they would stash their newfound wealth in a safe investment and live off the interest. When they first crafted this plan more than three decades ago, it wasn't implausible. But a million dollars isn't what it used to be, and neither is the interest you can earn off it.

Indeed, long-term Canadian government bond yields stand at just 2%, far from their 18% peak in September 1981. These yields look even skimpier in inflation-adjusted terms. The 1.5% expected inflation rate implied by long-term real return government bonds leaves investors with a 0.5% real yield.

The epic fall in interest rates led to smaller yields, but because bond prices and yields move in opposite directions, it powered outsized gains for bond holders: From its 1980 launch through February 2016, the FTSE TMX Universe Index -- Canada's bellwether investment-grade bond benchmark -- returned 9.1%, earning it a 3% premium over risk-free Treasury bills and a 0.6% lead over the S&P/TSX Composite Index.

That's out of whack with historical norms: According to Credit Suisse, investment-grade Canadian bonds earned just 0.7% over risk-free T-bills from 1900 to 2014, and 1.8% from 1965 to 2014, as stocks beat bonds by about 3% over both periods. Because asset class returns tend to revert to historical averages, bonds will likely deliver subpar long-term results both in absolute terms and relative to stocks. Ultra-low yields also portend weak performance, as yields comprise the largest part of fixed-income returns.

Investors have long expected interest rates to rise from generational lows. The market, helped by central bankers, continues to defy these expectations, but there probably will be a day when they don't. Given the inverse relationship between yields and bond prices, higher rates could mean negative returns, even before inflation.

It's true that active managers can adjust to the threat of higher rates by making their portfolios less rate-sensitive than their benchmarks. Forecasting the timing, magnitude and duration of higher rates is no easy feat, though. Just ask Canadian bond managers who began 2015 expecting rates to rise only for the Bank of Canada to go in the other direction.

Uninspiring returns and scant yields? Sign me up!

Given their less-than-enticing prospects, it's tempting to forgo bonds altogether. Stocks sound like a more attractive source of income. There may be a case for holding a higher-than-normal allocation to stocks, but bonds play an important role as a portfolio diversifier. From January 1980 to January 2016, the TMX Universe's correlation with domestic stocks, as measured by the S&P/TSX Composite Index, clocked in at 20%. These diversification benefits have been strongest when investors need them most: In equity bear markets since January 1980, the correlation between domestic stocks and investment-grade bond returns has been just 1%.

Indeed, investment-grade bonds have been dutiful protectors against stock market volatility. When the S&P/TSX Composite Index dropped 33% in 2008, for example, the TMX Universe climbed 6.4%. And as the Euro crisis and U.S. credit rating downgrade unnerved stock markets in 2011, the investment-grade bond universe rose 9.7% while domestic equities fell by nearly 9%. Lastly, as falling oil prices helped drag the TSX Composite to an 8% loss in 2015, the TMX Universe turned in a healthy 3.5% gain.

What investment-grade bonds lack in return potential, they make up for in safety and stability.

You get what you don't pay for

In a low-return world, costs should play a more decisive role in bond fund performance. After all, a fund's management-expense ratio will eat a bigger share of a fund's yield, leaving fund holders with a smaller one; a 1% MER chews up half of a 2% yield but a quarter of a 4% yield. A sure-fire means for investors to maximize their take is to minimize their costs.

Low-cost ETFs dependably leave investors with a larger slice of the pie than active alternatives. Active bond managers have hardly bathed themselves in glory versus their passive competitors. Just 5% of actively managed funds in the Canadian Fixed Income category survived and outperformed  iShares Canadian Universe Bond ETF (XBB) -- which tracks the TMX Universe index -- on a risk-adjusted basis over the 10-year period ended December 2015. The future is likely to be at least as tough for active managers in the category as the past.

Our favourite Canadian Fixed Income ETF,  Vanguard Canadian Aggregate Bond ETF (VAB), is likely to capture a bigger chunk of bond market returns than XBB, whose 0.33% MER is more than double VAB's 0.13% price tag. VAB ties iShares Core High Quality Canadian Bond ETF (XQB) for cheapest option in the category. Neither dazzle on the yield front; their yields-to-maturity clock in at 2.8% and 2.7%, respectively. But because they rely on high-grade government and corporate bonds, they should insulate portfolios from stock market volatility. We like the Vanguard fund because it represents a broader swath of the investable Canadian bond market, but the iShares offering is appealing because it takes less interest-rate risk, if at the cost of heavy concentration in financials.

This isn't to rule out active management altogether. In fact, just over 50% of Canadian Fixed Income managers outperformed the TMX Universe before fees. If large numbers outperform before fees, there must be some price where active managers stand a fighting chance. Our Gold-rated funds in the category --  PH&N Bond and  PH&N Total Return Bond -- place in the cheapest 10% of the category (including passive funds), with MERs of 0.60% and 0.61%, respectively. The funds have modestly outperformed XBB over three- and 10-year periods and matched it over five years. It says something about how difficult it is to outperform in the category if its actively-managed elite finish only slightly ahead of the passive alternative over most time periods.

Can't we all get along?

The active/passive debate is often polarizing. Proponents of both sides insist investors choose one camp over the other. The fact is both approaches can coexist within a portfolio. While plain-vanilla active managers face long odds, those focused on less-efficient areas of the bond market stand a better chance of success. These funds deliver richer income streams, which could dovetail nicely with a stability-providing core passive holding.

Gold-rated Canso Corporate Value, for instance, has built one of the best track records of any Canadian bond fund with a go-anywhere approach meshing investment-grade domestic corporate bonds and global high-yield issuers. (For investors who can't meet its $25,000 minimum investment, Lysander-Canso Corporate Value Bond has a $5,000 minimum, albeit at a higher MER.)

Our high-yield favourites, including Fidelity American High Yield and PH&N High Yield Bond (currently closed to new investments), have excelled thanks to seasoned management and deep research. Silver-rated Manulife Strategic Income lands in the High Yield Fixed Income category, though its eclectic approach includes investment-grade and high-yield bonds in Canada, the United States and internationally, including in developed markets. Managers Daniel Janis, Thomas Googins and Kisoo Park won Morningstar's 2015 Fixed-Income Manager of the Year award for their efforts.

About Author

Christopher Davis

Christopher Davis  Christopher Davis is Director of Manager Research at Morningstar Canada.