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Best Returns May Be In The Back Yard

The bond market has come to a fundamental divide. Canadian and American short term bonds pay so little and, in turn, money market funds and bank accounts too little, that off-farm fixed income investing has to be rethought. After all, getting a pittance on your cash is hardly a way to make a living.

We are in a period of very tough times. Global equity markets look to the dismal employment statistics and glum growth numbers in the U.S. and infer that what happens in America will also happen to them. Canadian markets are closely tied to those in the U.S., so risk avoidance is now the watchword on the Toronto Stock Exchange. People buy government bonds to avoid all chance of loss. Trouble is, they are paying so much to avoid loss that they have left the bonds with virtually no return.

If you choose to lend a sum to the U.S. Treasury for two years and you are able to get a good price from your bond dealer, you will get 0.20 per cent per year to maturity for your troubles. Two year Canada bonds will return 1.02 per cent, still a skinflintish payoff for having faith in government. Five year GICs offer little more than three per cent. The average return of Canadian money market funds for the 12-months ended July 31, 2011 was get ready for it 0.35 per cent for the whole year.

Bond yields have crumbled to the point that interest flows, which are usually a large part of the reason for buying bonds, no longer offer much cover for declines in bond prices. Eventually, of course, rates will rise. That leaves the market with a split personality. High quality government debt pays zilch or close to it. Global junk, such as Greek sovereign debt, which was priced to yield 46.5 per cent per year at the beginning of September, reflects an expectation of default no matter what politicians say. A gambler can take a ride on this kind of risk, though the odds of making money are better in Vegas.

With U.S. government bonds priced for a prolonged recession in which even a fraction of one per cent yield may look good, Government of Canada bonds have gotten a lot of admiring looks from foreign investors. But there is not too much fat in our bonds. Conventional 30-year Government of Canada bonds offer just 2.89 per cent per year for three decades of nail biting over government deficits. Corporate debt looks much better.

There are good yields to be had on solid bonds. For example, a Sun Life Financial 10-year issue due in 2021, recently priced to yield 4.45 per cent, offers 196 basis points more yield that a Canada that pays 2.49 per cent to maturity. Go further out and the returns are fatter. A GE Capital Canada 5.83 per cent issue due Oct. 22, 2037 recently priced to yield 5.3 per cent to maturity and backed by GE Capital in the U.S. offers a 2.2 per cent spread over the 30 year Canada. These are good bonds, but getting them can be tough. Dealers sell out of inventory and if they don t have it, you won t get them. The alternative is to buy into a bond mutual funds with a good track records. The problem is that fund managers face the same odds you do. They can use trading tricks the private investor cannot shorting bond futures, for example. That means that if bond prices fall on rising interest rates, the fund can make money. Bond fund managers can short bond futures and have the ability to trade on paper-thin spreads (the difference between buy and sell prices).

If you do choose to buy into a bond mutual fund and if the purchase is for a non-registered account, check on the fund s accounting for distributed earnings. Some funds stick all tax liability for interest and gains to unit holders at the end of the year. Others have ways of distributing the tax liability to those who actually got the interest and gains.

For RESPs, RRSPs and TFSAs, tax accounting is irrelevant. But for taxable accounts, it can make the difference between gain and loss, smiles or tears.

The alternative is to buy a bond exchange traded fund. ETFs are sold like stocks and can be priced minute by minute on stock exchanges. There are many flavours of the things. All offer rock bottom fees and all have hands-off management. Low fees are a redeeming quality, of course. You can get some ETFs for 25 basis points one quarter of one per cent per year. That s a fourth of the fee charged by some excellent managed bond funds. The problem is that in the present bond market, every ETF that is built on a bond index, as almost all are, will just show how awful bond yields are. You need a smart manager to beat those indices. So check a list of bond funds on a web source like www.globefund.com and review some of the bond ETFs offered by outfits like Claymore Investments. Shop carefully, for the market is unforgiving.

For the private investor with off-farm money to invest, keeping cash in the bank may be sensible. There is not much money to be made, but you won t lose much either.

It may be time to think about reinvesting more money in the farm, livestock or equipment, whatever looks profitable. For now, bonds sure aren t and stocks are as unpredictable as ever. And if you want, spend the money on a nice holiday. With so little to be made from low risk investing, it s time to realize that, in the end, money is ultimately to be enjoyed.

AndrewAllentuck smostrecentbook:When CanIRetire?PlanningYourFinancialLife AfterWork,waspublishedearlierthisyear byPenguinCanada

About the author

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Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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