Bond ETFs an alternative to funds

Let's talk about the fixed-income part of your investments.

Stay with me here -- bonds are dead boring to many, but they're essential to a balanced portfolio. They're also a bit of a problem to buy.

Purchasing a bond directly means taking a leap into the unknown if you're a small investor. Only your broker knows for sure how much commission you're paying.

Bond mutual funds are an alternative, but they're strikingly expensive in terms of the ongoing management fees they charge.

Now there's a third option, exchange-traded bond funds. You buy them like a stock, then hold them in your portfolio for the interest they pay out twice a year.

Exchange-traded bond funds aren't an ideal choice if you've only got a small amount of money to invest, but for many investors they're well worth considering as a replacement for bond funds and bonds.

Two exchange-traded bond funds were introduced in Canada last week by Barclays Global Investors, the company behind i60s (XIU-TSE), an exchange-traded fund that tracks the S&P/TSE 60 index of big blue-chip stocks. Barclays has also issued dozens of U.S. ETFs listed on the American Stock Exchange.

One of the new bond funds, the iG5 (XGV-TSE), will give you the yield of a Government of Canada five-year bond. The other, known as the iG10 (XGX-TSE), produces a 10-year Canada bond yield.

Actually, you make the five- or 10-year bond yield minus 0.25 per cent, which is the management expense ratio for the two funds. The average MER for a Canadian bond fund is 1.74 per cent -- think of this as the price you pay for professional management that may or may not outperform a five- or 10-year bond.

If you buy a bond rather than a bond fund, you don't have to worry about a MER. But you do have to pay a commission, one that's invisibly folded into the bond's price and yield as presented to you by your broker. If you're a favoured client, you pay a lower price for your bond and thus receive a higher yield (bond yields and prices move in opposite directions). For small fish, it's just the opposite.

Barclays is a huge outfit, which means it gets a better deal than the average small investor when it buys bonds for its two new ETFs. The net result here is that you may be able to get a higher yield from an iG5, say, than from a five-year Canada bond bought through your broker.

The downside of bond ETFs, and ETFs in general, is that you have to pay a brokerage commission every time you buy or sell. The cost with an on-line broker would be between $24 and $33, which is a lot if you have $500 to invest. By the way, you can buy as many iG5 or iG10 units as you want at a time.

For most retail investors, the best way to play an exchange-traded bond fund is to hold it indefinitely for interest payments made at the end of every June and December. Be warned -- the price of your units will fall if interest rates rise, and vice versa. If your units move up smartly, you can sell them for a capital gain.

If you hold an actual bond for income, you don't have to concern yourself much with rate volatility because the bond pays out its face value when it matures. No matter how much the bond's price might bounce around, you should get your money back.

With bond ETFs, there's no similar maturity date. This means you cannot count on getting your initial capital back on a specific date.

People with a long investing horizon don't really need to worry about this. They can just hang on to their units and collect interest payments until an opportune time to sell comes along.

But if you're counting on recouping your capital after a set period, exchange-traded bond funds may offer too much uncertainty.

Another thing to be aware of with these funds is that you can't have your interest payments automatically reinvested into new units, like a mutual fund would. As an alternative, you can pool your interest and buy new units periodically, or redeploy the interest elsewhere in your portfolio, possibly by holding it as cash.

An obvious question facing investors is whether to pick the iG5 or the iG10.

Broadly speaking, a 10-year bond would offer a little more volatility than a five-year bond, with the compensation of an extra 0.1 to 0.2 of a percentage point in yield. Five-year Canada bonds have a slightly higher yield than 10-year bonds right now, but this is unusual.

With the introduction of iG5s and iG10s, it's now possible for investors to construct a portfolio entirely out of exchange-traded funds. The only equity ETFs available now in Canada are the i60 and the DJ40 (DJF-TSE) offered by State Street Global Advisors, but several new Barclays products will appear in the weeks ahead.

If you're looking for an alternative to mutual funds, this is where the action is. rcarrick