Absolute return bond funds (also called tactical bond funds) aren’t exactly new to global investors. Many options have been available in Europe and the U.S. for the past five to six years. However, these funds are just beginning to make an appearance in Canada. With a couple of options now available, Canadian investors may be wondering if these funds are worth a closer look. [Also see Mutual Fund Basics – Understanding Mutual Funds]

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Why consider absolute return bond funds?

There are many cautious investors who put a portion of their portfolios into cash. And in a prolonged low-interest rate environment, many of these investors may be frustrated by the extremely low (often 0%) interest being offered on savings accounts. They begin to look into other types of investments that can guarantee their capital, yet provide a slightly better return. But at the same time, in a prolonged low-interest rate environment, investors begin to anticipate the inevitable rise in interest rates, so they tend to avoid investing in longer-duration bonds. What’s an investor to do?

Enter the absolute return bond fund, a product that allows the fund manager to increase or decrease the fund’s duration as interest rates rise and fall—typically within a certain range (say plus or minus a couple of years) of a benchmark index’s duration.

How do these funds work?

They aren’t simple, and anyone considering investing in an absolute return bond fund should ensure that it’s being managed by an experienced fund manager. The funds use a range of complex investment strategies, including yield curve positioning, duration management, derivatives, and currency hedging to select a variety of investment grade and high-yield bonds across sectors and durations. The ultimate goal is to protect investors’ capital while beating the return of the benchmark. Ideally, investors will see a positive return (regardless of how small) whether interest rates rise or fall.

Who should consider investing in these funds?

These funds are mainly for cautious investors who aren’t impressed with the low returns their getting on their savings accounts but who aren’t willing to take on much more risk. Investors should also have an investment horizon of about three to five year, as that’s how long it has traditionally taken many of these funds to meet their return targets.

Are they worth a closer look?

So, with many savings accounts currently paying 0.25% interest or less, are absolute return bond funds worth a closer look? Maybe not quite yet. While the goal of these funds is to preserve capital while beating a certain benchmark—say the DEX Universe Bond Index—that’s just a goal, not a guarantee. And while investors can be relatively confident that they won’t lose capital, the returns on these funds haven’t been impressive so far. Not to mention that, as with all managed funds, investors will pay management fees that will further diminish returns. Finally, options already exist for investors who want to preserve capital while seeking an incrementally better return than savings accounts: savings bonds and Guaranteed Investment Certificates. While investors shouldn’t discount absolute return bond funds, they might want to approach with caution. At least for now.