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inside the market

If the long bull market for bonds isn't over, it's certainly taking a long coffee break.

Returns from bond mutual funds and exchange-traded funds have deteriorated sharply in the past 12 months and, in some cases, have turned very slightly negative. That's quite a comedown from the 10-year average annual total return (changes in bond prices plus interest) of 5.2 per cent for the FTSE TMX Canada Universe Bond Index.

Many of the country's largest Canadian bond mutual funds were down as much as 0.5 per cent for the 12 months to March 31. The iShares Canadian Universe Bond Index ETF (XBB), which tracks the universe bond index, eked out a 0.4 per cent gain over that period. The Vanguard Canadian Aggregate Bond Index ETF (VAB), which tracks a different bond benchmark index, had a 12-month gain of 0.7 per cent.

Volatile interest rates are behind the setback for bonds in the past 12 months. We've had two cycles over that period of rates falling on pessimism about the economy and then rebounding. The latest rebound began in late February and has certainly weighed on bonds and bond funds (rising rates depress bond prices).

Expect more of this up-and-down pattern for rates, and more weak returns from bonds. A sharp, sustained decline in bond yields could help bonds, but that's unlikely unless the economy worsens markedly. Investors need to make two adjustments in this kind of up-and-down market. First, they need to adopt a realistic attitude toward bonds. Hold them as a hedged against a stock market decline or economic recession, not as an engine for generating the 5.2 per cent average annual total returns of the past decade.

Second, fees on bond funds must be addressed by investors. Talented portfolio managers can, conceivably, justify hefty fees on a bond fund with consistent index-beating returns. But a lot of investors would be better off with a cheap index-tracking bond ETF. Vanguard has some of the cheapest bond ETF fees around, as does the new TD Canadian Aggregate Bond Index ETF (TDB) and the iShares Core High Quality Canadian Bond Index ETF (XQB).

Check out my Portfolio Strategy column this Saturday for a survey of core Canadian bond ETFs, including fees and other key variables.