The bond market can be complicated and investing in some bonds, like corporate bonds, can be writhe with risk. Real return bonds, in particular, have complex structures that would require more than a basic understanding of the economic climate and fixed-income markets. Yet, there\'s no question that bonds are an integral part of your diversified investment portfolios. Is there an easier way to invest in bonds?

Benefits of Bond Funds

To achieve the benefits of bond investing, while also reducing the risk that comes from investing in only a handful of bonds, bond mutual funds could be an ideal solution for you.

Diversification

Most bond funds are comprised of a variety of issues from government to corporate bonds, featuring different terms to maturity and yields. This diversification provides superior risk/return benefits to a small selection of bonds. To include corporate bonds, a diversified portfolio would require equity-like diversification. A diversified portfolio could also feature real return bonds as a hedge against inflation, and government issues that would diversify the term and credit quality exposure. That level of diversification would require a lot of capital from the investor.

Professional Portfolio Management

Purchasing bonds, especially corporate issues, is a lot like buying stocks. Bond funds are managed by professionals who use rigorous research methods to determine which corporate bonds they should invest in.

Risk Management

A bond fund employs a team of credit specialists who provide in-depth credit analysis and ongoing monitoring to reduce and avoid the risk of credit default. Recent high-profile debacles have shown that credit rating agencies are not always accurate and they cannot always provide timely rating changes.

Convenience

The minimum investment requirements for bond funds are very low, making them easily accessible to most investors. As well, interest earned through distribution payments can be readily reinvested into additional units of the fund, regardless of the amount. Bond funds can also reinvest coupon payments generated from its sizeable portfolio. By contrast, interest earned on individual debt securities can be difficult to reinvest due to the relatively small size of coupon payments versus the minimum investment requirements. Investors can sell their bond funds in portions or all of their investment at any time as they are sold in units, rather than multiples of $1,000. Bond fund investors are also not confined by maturity dates.

Minimize the Downside of Corporate Bonds

Along with being higher risk investments than government bonds, corporate bond purchases tend to have ample embedded transaction costs, which can be significantly higher for individual purchases versus block purchases made by a fund. As well, when current interest rates drop below issue rates, there is the potential risk that an issuer could call a bond, in favour of borrowing at a lower cost. Despite the downside of corporate bonds, they are becoming increasingly vital in a fixed-income portfolio as government issues continue to dissipate due to falling debt requirements, such as the discontinuation of 30-year treasuries by the U.S. government.

Liquidity of Real Return Bonds

The lack of liquidity in the secondary market precludes most individual investors and even some institutions from market participation. This lack of liquidity is attributed to the limited number of real return bond issues available (currently only three in Canada) and the fact that most real return bond purchasers buy-and-hold for the inflation protection benefits.

Less Work at Tax Time

Distributions paid to bond fund unitholders in the form of interest and capital gains are calculated and recorded for investors through the issuance of a T3 slip. This significantly reduces the amount of work involved at tax time, particularly for income generated from real return bonds, as their complex nature makes interest and capital gains calculations more challenging.

To see how a bond program could help your portfolio, it\'s best to speak with a financial advisor.

This article was compiled by John Klotz., BA., CFP., CLU., CH.F.C., RHU. John is Vice President of LMS Prolink Ltd. You can reach John at johnk@lms.ca or phone (416)-595-7484 ext. 305