How bond funds are categorized

Credit risk is another key aspect that investors must be aware of, says Jason Thompson, vice president, product development at Toronto-based Mackenzie Investments. "What is the quality of the underlying investments, as determined by the bond-rating agencies? You can be in investment-grade bonds, which are higher-quality or in non-investment grade bonds, which are rated below BBB and lower-quality. That's important to understand, because the higher quality bonds tend to be more conservative and have less risk of default, whereas higher-yield bonds tend to have higher risks. It's important to choose carefully."

What follows, then, are the seven categories, their attributes and potential risks and rewards. The definitions are derived from the Canadian Investment Funds Standards Committee, which oversees the categorizations of all mutual funds.

Canadian Short Term Fixed Income: The least risky of all the bond categories, these funds must invest at least 90% of their holdings in fixed income securities denominated in Canadian dollars with an average duration less than 3.5 years. As well, the bulk of the bonds must be investment-grade and not more than 25% can be in non-investment-grade or high-yield fixed income. "Volatility will be pretty low, based on the 3.5 years measure," says LeClair, adding that some fund managers may run a portfolio with duration as low as one year. "That's one of the first things investors should ask. 'What is the duration and what are the constraints on duration?' That will tell you what kind of a mandate the manager has." Examples include CIBC Short-Term Income and RBC Canadian Short Term Income.

Canadian Fixed Income: The largest category, these bond funds must invest at least 90% of their holdings in Canadian-dollar-denominated bonds that have an average duration greater than 3.5 years, but less than 9 years. The funds must invest the bulk of the portfolios in investment-grade bonds and no more than 25% can be in high-yield securities. Because the category offers greater flexibility, it's not surprising that "not all funds are the same, because there are some differences within the category," observes Thompson. He notes, as well, that up to 30% of a fund's assets may be held in foreign bonds which will be treated as Canadian content so long as the currency exposure is hedged back into Canadian dollars. "You can have funds at the lower end, in terms of duration, or at the higher end. That's why it's helpful to work with an advisor or do more research before you make a call." Representative of this category are Mackenzie Canadian Bond and Manulife Bond.

Canadian Long Term Fixed Income: A more volatile category, these funds must invest in Canadian-dollar-denominated bonds with an average duration greater than 9 years. The average credit quality must be investment-grade, although funds are permitted to own up to 25% in high-yield bonds. These funds were well served following the financial crisis, when long-term bonds saw their prices soar and reaped healthy capital gains. But, cautions Thompson, investors should be extra-careful given that rock-bottom interest rates may eventually start to climb. "These funds with the longest durations would be the most sensitive to an increase in interest rates," says Thompson, adding that in 2013 long term bonds were hit the most when yields spiked for a few months. Representative of this category are Beutel Goodman Long Term Bond and National Bank Long Term Bond.

Canadian Inflation Protected Fixed Income: These funds must invest at least 90% of their holdings in Canadian-dollar-denominated inflation-protected bonds, otherwise known as real-return bonds. The average credit quality is investment-grade and no more than 25% can be held in high-yield bonds. As the funds invest in long-dated bonds, duration tends be at the highest end of the spectrum.

"This category, and the next three, are what I call speciality income funds," says LeClair, adding that they can be more volatile than mainstream bond funds. Although the inflation protected category has generated strong returns historically, LeClair cautions that it benefitted not from rising inflation but a combination of long durations and falling yields. "People should be careful because this situation may not continue forever. In fact, the reverse could also work against them, if we have a rising rate environment." Representative funds in this category include Mackenzie Real Return Bond and TD Real Return Bond.

Global Fixed Income: These funds must invest less than 90% of their holdings in Canadian-dollar issues and must be primarily investment-grade securities, with a limit of 25% on high-yield bonds. Since the focus is global, currency risk is a predominant factor. "There is quite a mix of funds," says LeClair, noting that portfolio managers often combine currency, duration and credit in one package. "And the product can be much more volatile than a plain-vanilla bond fund. It's easy to see double-digit returns---but also double-digit losses. Before investing, you want a manager with a global reach and strong track record, someone who's been through the cycle," Representative of this category are Mackenzie Global Bond and RBC Global Bond.

High Yield Fixed Income: These funds, the most volatile of bond funds, must invest mainly in non-investment-grade securities, but can go as low as 25% in this area. These funds have equity-like characteristics as they seek to invest in companies with improving fundamentals. If chosen well, funds will benefit from falling bond yields, as the so-called "spread" over investment-grade bonds narrows. Significantly, says Thompson, portfolio managers are not constrained by duration. "You can have short term securities, such as floating rate bonds, or much longer duration. You need to look under the hood, and ask, 'What type of high yield do I want? Do I want protection against rising interest rates? Or do I want to take on more risk and buy [longer-dated] lower-quality corporate bonds?' If the latter is the case, you have to be prepared for a little more volatility." Representative funds in this area include Mackenzie Floating Rate Income and Manulife Corporate Bond.

Preferred Share Fixed Income: These funds, a relatively new and small category, must invest at least 90% of their holdings in preferred shares. "Preferred shares are a credit product. They are ranked below bonds, and above equities. But in Canada, you get paid quite a bit more than a bond," says LeClair, noting that investors benefit from a tax advantage, as they are paid in dividends which attract less tax than interest income. While preferred shares often generate about 250-300 basis points in yield above government of Canada bonds, they are characterized by poor liquidity. "It's a small market, very credit intensive, and you can't switch duration with this type of product," says LeClair, noting that last year, as rates spiked, the funds saw modest negative returns. Examples include Manulife Preferred Income and Dynamic Preferred Yield Class.

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