By Jonathan Chevreau National Post FP Money Saturday, October 5, 2002

After watching stock markets drop six consecutive months, you've decided to throw in the towel and switch what's left of your battered equity fund portfolio to bond funds.

Bad timing.

If you're a typical mutual fund investor, you may be swayed by the latest performance data: the average Canadian bond fund returned 5.5% in the year ended Aug. 31, 2002, and enjoyed a compounded 5.7% over three years. The average foreign bond fund soared 9.3% on the year.

Yes, it would have been lovely to have owned nothing but bond funds the last three years, particularly in registered plans. But now is hardly the time for someone overweighted in stocks to go to the opposite extreme.

Such a switch so late in the bear market smacks of a classic "whipsawing" effect which afflicts fund holders chasing performance.

Put aside the possibility you may be selling your remaining equity funds near the bottom. As big a risk is that your freshly purchased bond mutual funds may lose money.

How's that? Interest rates are hovering near their lowest levels in more than 40 years. There is an inverse relationship between interest rates and bond prices, something most North American investors don't understand.

Over the past 10 years, fund investors have served as an excellent reverse indicator of future bond returns, says Dan Hallett, senior investment analyst with Windsor-based Sterling Mutuals Inc.

He points to late 1992, when Canadian bond funds returned 20%. By 1993, investors were pumping $1.6-billion into bond funds. Early in 1994, interest rates started rising, eventually jumping 3% on the year. Despite the first two hikes and a 7% loss in the bond market, Canadians hoovered up another $1.7-billion in bond funds that RRSP season.

As rates rose further, they then dumped $1.2-billion of bond funds over the rest of the year. By the time rates peaked in the spring of 1995, fund investors were still slow to catch on. They were redeeming while bond fund buy-and-holders enjoyed 10% gains.

Rates slowly fell the rest of the decade until the Fed started raising them again in 1999. Investors fled bonds again to pile into the Nasdaq bubble.

As they nursed their wounds when tech stocks crashed, bond fund investors enjoyed 8.5% returns by early 2001. Yet again, Canada's fund investors flocked to bond funds, buying $2.7-billion between the end of 2000 and August, 2002.

Based on similar recent behaviour, and ignoring economic and financial factors, "I'd say we're very close to the end of the bond bull," Hallett concludes.

That investors don't understand bonds was underscored last month in a 10-question survey which most Canadians flunked. Cartier Partners found 46% of those owning bonds directly or through funds believe they go up in value if interest rates rise.

The opposite is true: if rates rise, the value of bonds or bond funds goes down. Don't feel badly though. Seventy per cent of American investors misunderstand this too. And that's a problem because bond fund sales in the United States are hitting all kinds of records, according to Carter Partners CEO Dan Richards.

"It's a very different pattern than Canada. Here, bond funds haven't really taken off in a huge way. In the U.S., all kinds of alarm bells are going off."

Richards says people don't understand the inverse relationship between interest rates and bond prices because it's counterintuitive.

People know it's good news when the price of stocks or real estate rises, but need to learn it's bad news for bonds when interest rates rise.

"For most of my clients, the comprehension level of bonds is much less than stocks," agrees Vancouver-based advisor Adrian Mastracci.

As the bear market deepened, central banks kept cutting rates: 475 basis points or 4.75% in the U.S. Bond values rose with each cut. But with U.S. rates down to 1.75%, there's little room left to cut.

The bank rate in Canada is at 2.75% and most expect rates to start rising soon.

Judging by the behaviour of mutual fund investors, you might conclude the bond fund train has already left the station.

The standard protection against bond whiplash is to keep durations short: invest in bonds with less than five-year maturities, or invest in short-term treasury bills, money market funds or even ING Direct's high-interest savings account. If rates do rise, you gradually get better yields with short-term instruments.

If you own a "ladder" of strip bonds with different maturities, you can escape this problem if you hold each bond to maturity. But you have no such option with bond mutual funds.

"Bond funds are not bonds," notes KCM Wealth Management's Mastracci, "Bond funds do not carry the same principal and coupon guarantees that make bonds so attractive to investors looking for an income stream. Individual bonds mature on a specific date for a specific amount. The price of bond funds reflects the combined market value of all its holdings so investors are always looking at a moving target."

Worse, actively managed bond funds have high management expense ratios (MERs) of 1.8% a year: a further drag on historically low bond yields.

If you believe costs matter, try Gordon Pape's recommendation of the Barclays iG5 bond exchange-traded fund [XGV/TSX], which holds five-year Canada bonds. At 0.25%, the MER is low. Another option is TD Canadian Government Bond Index fund, with a MER of 0.47%, or bond funds from Perigee, McLean Budden, and Beutel Goodman, all with MERs under 0.8%.

In The Internet Wealth Builder, Pape suggests bond fund returns may be in the 5% to 6% range over the next year. He suggests those who already own bond funds or individual bonds hold them.

By now investors should have learned the lesson that portfolios 100% in either stocks or 100% in bonds court undue risk. So forget about timing either stock or bond markets. Investors are best served with balanced portfolios which always contain both asset classes.

However, that doesn't mean balanced mutual funds, which charge too much for the bond portion of their portfolios, says Duff Young, CEO of FundMonitor.com. Investors could switch to pure equity funds and use some of the above strategies for the bond portion.

NOTE: The information provided above is intended for general informational purposes only. It does not constitute advice for anyone's specific situation. Everyone should always first consult directly with their advisors to determine the appropriateness of any information contained above before taking any action. KCM Wealth Management Inc. assumes no responsibility for any loss or damage arising from the use of, or reliance upon the above information.