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Royal Bond Fund no refuge from stock crises

00:00 EST Tuesday, November 26, 2002

A bond fund sold by one of the big banks is the type of place an investor goes for refuge from stock market disasters such as WorldCom Inc., Adelphia Communications Corp. and Calpine Corp.

But if you owned the $1.8-billion Royal Bond Fund, you'd have been exposed to all of these companies in the past while, not to mention the debt of Latin American countries such as Brazil.

A column last week looked at how this Royal Bank of Canada fund was the worst performer among widely held Canadian bond funds in the 12 months to Oct. 31. During that time, it lost 2.9 per cent while the average fund made 2.6 per cent. In explaining the fund's record, lead manager Jim Davis said he made a wrong guess about the direction of interest rates.

A close look at Royal Bond's holdings this year indicates there were other difficulties as well, including investments in bonds issued by WorldCom, Adelphia and Calpine.

Each of these companies has delivered harsh losses to investors. WorldCom and Adelphia have become synonymous with corporate scandal, while Calpine is an energy company that has suffered in the aftermath of the Enron fiasco.

The likes of WorldCom and Adelphia would seem to be at opposite ends of the investing solar system from a Canadian bond fund. So what gives with Royal Bond?

It's simple, really. While other big bank bond funds tend to hold higher-grade government and possibly corporate bonds, Royal Bond tries to enhance returns with a small taste of corporate and foreign government bonds that offer more risk but also a higher potential return.

"We have a very strong and deep skill set here that many of our competitors don't have," Mr. Davis said yesterday. "We have five individuals who cover the corporate bond market in Canada and the United States. They have immense experience and a very enviable track record."

Mr. Davis said Royal Bond is well enough diversified that WorldCom, Adelphia and Calpine bonds amounted to less than 0.5 per cent of the fund's total portfolio. The net loss associated with these bonds amounted to about 0.15 per cent.

"We're trying to get the best returns for our unitholders, and we're trying to do so in the most diversified way possible," he said.

This past year won't go down as a banner year for Royal Bond's approach with riskier bonds. In fact, an RBC Funds commentary about Royal Bond's performance in October makes brief mention of how the fund has been reducing its most risky credit exposures.

Here's a representative transaction found by mutual fund analyst Dan Hallet of Sterling Mutuals in Windsor, Ont. Mr. Hallett was kind enough to help sift through some of Royal Bond's financial statements. He spotted that on April 22, Royal Bond spent $2.17-million on WorldCom bonds with a par value of $2-million. Two days later, the fund spent $486,235 on WorldCom bonds with a par value of $500,000.

Jump ahead a day and Royal Bond was selling both bond purchases for a total of $2.24-million, which was 15.6 per cent less than the $2.66-million purchase price.

While all of this was going on, two major bond-rating agencies were lowering their ratings on WorldCom in response to an April 19 forecast from the company in which $1-billion was sliced off its 2002 revenue estimate.

Royal Bond's WorldCom adventure was short enough that it didn't appear on the a statement of investments and other net assets dated June 30. There were other interesting nuggets to be found in this statement, however.

One was an investment in U.S.-dollar Republic of Brazil bonds. The purchase price here was $8.4-million, while the June 30 value was $6.8-million, a 19-per-cent decline.

A $1.1-million investment in Adelphia bonds had fallen to $614,000, a drop of about 45 per cent, while an $8.9-million investment in Calpine fell about 16 per cent to $7.5-million.

Though minuscule in broad dollar terms, these setbacks didn't help a fund that was already coping with a wrong call on rates. Net result: A letdown for unitholders expecting the same modest but still tangible returns of other big bond funds.

While Royal Bond was losing 2.9 per cent, the $2.7-billion TD Canadian Bond made 3.8 per cent, the $1.4-billion Scotia Canadian Income Fund made 4.2 per cent and the $1.3-billion BMO Bond Fund made 2.4 per cent.

So, was Royal Bond out of line in buying debt issued by losers such as WorldCom and Adelphia? The short answer is no.

According to its stated investing objectives, the fund strives to provide a total return comprising income and capital growth by investing "primarily in high quality fixed-income securities issued by Canadian governments and corporations," as well as similar securities from outside Canada.

While the term "high quality" does set a certain tone here, there's nothing here to categorically exclude investing in WorldCom and such.

This leaves just one question: When RBC banking customers walked into a branch to buy some mutual funds, did they expect to hook up with a bond fund that has dipped its toe into the toxic pool of WorldCom et al?

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