Chapter 12
Bond Funds: When Boring Is Best
In This Chapter
Defining bonds
Knowing when and why to invest in bond funds
Understanding how bond funds differ from one another
Selecting short-, intermediate-, and long-term bond funds
Considering CDs, GICs, and other alternatives to bond funds
Many investors, both novice and expert, think that the b in bonds is for boring. And they’re partly correct. No one gets excited by bonds — unless she’s an investment banker, money manager, or broker who deals in bonds and makes big bucks because of them.
But take the time in this chapter to get the whole scoop on bonds. They may seem boring, but they generally offer higher yields than bank and money market accounts with less volatility than stocks.
Understanding Bonds
So what the heck is a bond? Let me try to explain with an analogy. If a money market fund is like a savings account, then a bond is similar to a certificate of deposit (CD). With a five-year CD, for example, a bank agrees to pay you a predetermined annual rate of interest — say, 4.5 percent. If all goes according to plan, at the end of five years of earning the 4.5 percent interest, you get back the principal that you originally invested.
Bonds work about the same way, only instead of banks issuing them, corporations or governments issue them. For example, you can purchase a bond, scheduled to mature five years from now, from a company such as Walmart. A Walmart five-year bond may pay you, say, 6 percent. As long as Walmart doesn’t have a financial catastrophe, after five years of receiving interest payments (also known as the coupon rate) on the bond, Walmart returns your original investment to you. (Note: Zero coupon bonds pay no interest but are sold at a discounted price to make up for it.)
The worst thing that can happen to your bond investment is that if Walmart filed bankruptcy, then you may not get back any of your original investment, let alone the remaining interest.
You shouldn’t let this unlikely but plausible scenario scare you away from bonds for these important reasons:
Bonds can be safer than you think. Many companies need to borrow money (and thus issue bonds) and are good credit risks. If you own bonds in enough companies — say, in several hundred of them — and one or even a few of them unexpectedly take a fall, their default (failure to pay back interest or principal on time) affects only a sliver of your portfolio and wouldn’t be a financial catastrophe. A bond mutual fund and its management team can provide you a diversified portfolio of many bonds.
You’re rewarded with higher interest rates than comparable bank investments. The financial markets and those who participate in them — people like you and me — aren’t dumb. If you take extra risk and forsake FDIC insurance, you should receive a higher rate of interest investing in bonds. Guess what? Nervous Nellie savers who’re comforted by the executive desks, the vault, the guard in the lobby, and the FDIC insurance logo at their local bank should remember that they’re being paid less interest at the bank because of all those comforts.
If you like the government backing afforded by the FDIC program, you can replicate that protection in bond mutual funds that specialize in government-backed securities. (See the section “Eyeing Recommended Bond Funds,” later in this chapter.)
In the last section of this chapter, “Exploring Alternatives to Bond Funds,” I discuss some potentially higher yield alternatives to investing in bond funds. There, you see that with those higher yields comes greater risk. After all, there’s no free lunch in the investing world.
Sizing Up a Bond Fund’s Personality
Bond funds aren’t as complicated and unique as people, but they’re certainly more complex than money market funds. And thanks to some shady marketing practices by particular mutual fund companies and salespeople who sell funds, you have your work cut out for you in getting a handle on what many bond funds really are investing in and how they differ from their peers. But don’t worry: I explain these important details for the good funds that I recommend later in this chapter.
After you know four key facts about bond funds — maturity, credit rating, the different entities that issue bonds, and, therefore, the tax consequences on those bonds — you can put the four together to understand how mutual fund companies came up with so many different types of bond funds. For example, you can buy a corporate intermediate-term high-yield (junk) bond fund or a long-term municipal bond fund. In the following sections, you see the combinations are many.
Maturity: Counting the years until you get your principal back
In everyday conversation, maturity refers to that quiet, blessed state of grace and wisdom that you develop as you get older (ahem). But that’s not the kind of maturity I’m talking about here. Maturity, as it applies to bonds, simply refers to when the bond pays you back — it could be next year, 5 years from now, 30 years from now, or longer. Maturity is the most important variable by which bonds, and therefore bond funds are differentiated and categorized.
You should care plenty about how long a bond takes to mature because a bond’s maturity gives you a good (although far from perfect) sense of how volatile a bond will be if interest rates change (see Table 12-1). If interest rates fall, bond prices rise.
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Table 12-1 Interest Rate Increases Depress Bond Prices |
|
|
Bond Type |
Price Change If Rates Suddenly Rise 1 Percent* |
|
Short-term bond (2-year maturity) |
–2 percent |
|
Intermediate-term bond (7-year maturity) |
–5 percent |
|
Long-term bond (20-year maturity) |
–10 percent |
*Assumes that bonds are yielding approximately 7 percent. If bonds were assumed to be yielding more, then a 1 percent increase in interest rates would have less of an impact. For example, if interest rates are at 10 percent and rise to 11 percent, the price change of the 20-year bond is –8 percent.
Bond funds are portfolios of dozens — and in some cases, hundreds — of individual bonds. You won’t need to know the maturity of every bond in a bond mutual fund. A useful summarizing statistic to know for a bond fund is the average maturity of its bonds. In their marketing literature and prospectuses, bond funds typically say something like, “The Turbocharged Intermediate-Term Bond Fund invests in high-quality bonds with an average maturity of 7 to 12 years.”
Bond funds usually place themselves into one of three maturity categories:
Short-term bond funds: These funds concentrate their investments in bonds maturing in the next few years.
Intermediate-term bond funds: This category generally holds bonds that come due within five to ten years.
Long-term bond funds: These funds usually own bonds that mature in 15 to 20 years or so.
These definitions aren’t hard and fast. One long-term bond fund may have an average maturity of 14 years while another may have an average of 25 years.
You can run into problems when one intermediate-term fund starts bragging that its returns are better than another’s. It’s the old story of comparing apples to oranges. When you find out that the braggart fund has an average maturity of 12 years and the other fund has a maturity of 7, then you know that the 12-year fund is using the “intermediate-term” label to make misleading comparisons. The fact is, a fund with bonds maturing on average in 12 years should be generating higher returns than a fund with bonds maturing on average in 7 years. The 12-year fund is also more volatile when interest rates change.
The greater risk associated with longer term bonds, which suffer price declines greater than do short-term bonds when interest rates rise, often comes with greater compensation in the form of higher yields.
Most of the time, longer term bonds pay higher yields than do short-term bonds. You can look at a chart of the current yield (“today”) of bonds of varying length maturities, which is known as a yield curve. Most of the time, this curve slopes upward (see Figure 12-1). Many leading financial publications and Web sites carry a current chart of the yield curve.
Duration: Measuring interest rate risk
If you’re trying to determine the sensitivity of bonds and bond funds to changes in interest rates, duration may be a more useful statistic than maturity. A bond fund with a duration of ten years means that if interest rates rise by 1 percent, then the value of the bond fund should drop by 10 percent. (Conversely, if rates fall 1 percent, the fund should rise 10 percent.)
Trying to use average maturities to determine what impact a 1 percent rise or fall in interest rates will have on bond prices forces you to slog through all sorts of ugly calculations. Duration is no fuss, no muss — and it gives you one big advantage, too. Besides saving on number crunching, duration enables you to compare funds of differing maturities. If a long-term bond fund has a duration of, say, 12 years, and an intermediate fund has a duration of 6 years, the long-term fund should be about twice as volatile to changes in interest rates.
Figure 12-1: A yield curve chart.
Although duration is easier to work with and a better indicator than average maturity, you’re more likely to hear about average maturity because a fund’s duration isn’t that easy to understand. Mathematically, it represents the point at which a bondholder receives half (50 percent) of the present value of her total expected payments (interest plus payoff of principal at maturity) from a bond. Present value adjusts future payments to reflect the fact that money received in the future has less value, primarily because of increases in the cost of living (inflation).
If you know a bond fund’s duration, which you can obtain from the fund company behind the bond fund you’re interested in, you know almost all you need to know about its sensitivity to interest rates. However, duration hasn’t been a foolproof indicator: During particular periods when interest rates have risen, some funds have dropped more than the funds’ durations predicted. But bear in mind that some heavy investing in unusual securities (such as derivatives) was required to make duration unreliable — so the duration values of the better funds, which I recommend in this chapter, usually work just fine as a guide. Also be aware that other factors — such as changes in the credit quality of the bonds in a fund — may affect the price changes of a bond fund over time.
Credit quality: Determining whether bonds will pay you back
Bond funds also differ from one another in terms of the creditworthiness of the bonds that they hold. That’s just a fancy way of saying, “Hey, are they gonna stiff me or what?”
Every year, bondholders get left holding nothing but the bag for billions of dollars when their bonds default. You can avoid this fiasco by purchasing bonds that are unlikely to default, otherwise known as high-credit-quality bonds. Credit rating agencies — Moody’s, Standard & Poor’s, Duff & Phelps, and so on — rate bonds based on credit quality and likelihood of default.
The credit rating of a security depends on the company’s (or the government entity’s) ability to pay back its debt. Bond credit ratings are usually done on some sort of a letter-grade scale: For example, in one rating system, AAA is the highest rating, with ratings descending through AA and A, followed by BBB, BB, B, CCC, CC, C, and so on. Funds that mostly invest in
AAA and AA rated bonds are considered to be high-grade or high-credit-quality bond funds; bonds of this type have little chance of default. These bonds are considered to be investment quality bonds.
A and BBB rated bonds are considered to be general bond funds (moderate-credit-quality). Like AAA and AA rated bonds, these bonds are known as investment quality bonds.
BB or lower rated bonds are known as junk bond funds (or by their more marketable name, high-yield funds). These funds expect to suffer more defaults — perhaps as many as a couple of percent of the total value of the bonds per year or more. Unrated bonds have no credit rating because they haven’t been analyzed or evaluated by a rating agency.
Lower quality bonds are able to attract bond investors by paying them a higher interest rate. The lower the credit quality of a fund’s holdings, the higher the yield you can expect a fund to pay (to hopefully more than offset the effect of potential defaults).
Issuer: Knowing who you’re lending to
Bond funds and the bonds that they hold also differ according to which type of entity is issuing them. Here are the major options:
Treasuries: These are IOUs from the biggest debtor of them all — the U.S. federal government. Treasuries include Treasury bills (which mature within a year), Treasury notes (which mature between one and ten years), and Treasury bonds (which mature in more than ten years). All Treasuries pay interest that’s state-tax-free but federally taxable.
Municipals: Munis are state and local government bonds that pay federally tax-free and state-tax-free interest to those who reside in the state of issue. The governments that issue municipal bonds know that the investors who buy municipals don’t have to pay most or any of the income tax that normally would be required on other bonds — which enables the issuing governments to attract buyers at a lower rate of interest. Later in this chapter (in the section “How to obtain tax-free income”), I explain how to determine if you’re in a high enough tax bracket to benefit from muni bonds.
Corporates: Issued by companies such as General Mills and Hewlett Packard, corporate bonds pay interest that’s fully taxable.
Mortgages: You can actually get back some of the interest you’re paying on your mortgage by purchasing a bond fund that holds it! Some bond funds specialize in buying mortgages and collecting the interest payments. The repayment of principal on these bonds is usually guaranteed at the bond’s maturity by a government-sanctioned organization such as the Government National Mortgage Association (GNMA, also known as Ginnie Mae) or the Federal National Mortgage Association (FNMA or Fannie Mae).
Convertibles: These are hybrid securities — bonds that you can convert into a preset number of shares of stock in the company that issued the bond. Although these bonds do pay interest, their yield is lower than nonconvertible bonds because convertibles offer you the upside potential of being able to make more money if the underlying stock rises.
International bonds: Bond funds (and individual investors) can buy most of the preceding types of bonds from foreign issuers as well. In fact, international corporate and government bonds are the primary bonds that foreign bond mutual funds may hold. International bonds are riskier because their interest payments can be offset by currency price changes and may be riskier due to political instability and insufficient information.
Management: Considering the passive or active type
Some bond funds are managed like an airplane on autopilot. They stick to investing in a particular type of bond (such as high-grade corporate), with a target maturity (for example, an average of ten years). Index funds that invest in a relatively fixed basket of bonds — so as to track a market index of bond prices — are good examples of this passive approach. Exchange-traded funds (ETFs) of bonds are bond funds (generally index funds) that trade on a major stock exchange. See Chapter 5 for more on ETFs.
At the other end of the spectrum are aggressively managed funds. Managers of these funds have significant freedom to purchase bonds that they think will perform best in the future. For example, if a fund manager thinks that interest rates will rise, he’ll buy shorter term bonds (remember that shorter term bonds are less sensitive to interest rate changes than longer term bonds) and keep more of a fund’s assets in cash. The fund manager may be willing to invest more in lower credit-quality bonds if he thinks that the economy is going to improve and that more companies will prosper and improve their credit standing.
Aggressively managed funds gamble. If interest rates fall instead of rise, the fund manager who moved into shorter term bonds and cash suffers worse performance. If interest rates fall because the economy sinks into recession, lower credit-quality bonds suffer from a higher default rate and depress the fund’s performance even further.
Some people think that predicting which direction interest rates and the economy are heading is fairly easy. The truth is that economic predictions are difficult. In fact, over long periods of time (ten or more years), meaningful predictions are almost impossible.
Investing some of your bond fund money in funds that try to be well positioned for changes in the economy and in interest rates may appear attractive. But remember that if these fund managers are wrong, you can lose more money. Over the long term, your best bet is efficiently managed funds that stick with a specific investment objective — such as holding intermediate-term, high-quality bonds — and don’t try to time and predict the bond market.
Trying to beat the market can lead to getting beaten. Some bond funds have fallen on their faces after risky investing strategies backfired (see Chapter 7). Interestingly, bond funds that charge sales commissions (loads) and higher ongoing operating fees are the ones more likely to have blowups. This may be because these fund managers are under more pressure to try and boost returns to make up for these higher fees.
Inflation-indexed Treasury bonds
In 1997, the U.S. federal government introduced a new type of Treasury bond that’s inflation proof: inflation-indexed Treasuries. These new Treasury bonds were designed to better meet the needs of inflation-fearing investors.
An investor with, say, $10,000 to invest could recently have purchased a ten-year, regular Treasury bond that yielded 4 percent interest, or about $400, annually. Now, contrast this regular Treasury bond with its new inflation-indexed brethren. The ten-year inflation-indexed bonds issued at the same time yielded about 1.5 percent. Before you think that this low yield is a rip-off, know that this is a real (as in not affected or eroded by inflation) rate of return of 1.5 percent.
The other portion of your return with these inflation-indexed bonds comes from the inflation adjustment to the $10,000 principal you invested. The inflation portion of the return gets added back into principal. So if inflation runs at, say, 2.5 percent, after one year of holding your inflation-indexed bond, your $10,000 of principal would increase to $10,250.
So, no matter what happens with the rate of inflation, the investor who bought the inflation-indexed bond, in my example, always earns a 1.5 percent return above and beyond the rate of inflation. If inflation leaps to 10, 12, or 14 percent, or more, as it did in the early 1980s, the holders of inflation-indexed Treasuries won’t have the purchasing power of their principal or interest eroded by inflation. Holders of regular Treasury bonds, however, won’t be as fortunate because at a continued double-digit annual inflation rate, holders of these 4 percent yield bonds would have a negative real (after inflation) return.
Because inflation-indexed Treasuries protect the investor from the ravages of inflation, they represent a less risky security. In the investment world, lower risk usually translates into lower returns.
Of course, the rate of inflation can and will change in the future. For the ten-year bonds chosen in my example, inflation needs to exceed 2.5 percent per year for the holders of the inflation-indexed bonds to come out ahead of those holding the regular Treasury bonds. If inflation were running at, say, 3 percent per year, the total return of inflation-indexed bonds would be 4.5 percent, exceeding the 4 percent on the regular Treasury bonds.
Income-minded investors need to know that the inflation-indexed Treasuries only pay out the real return, which in the preceding example was just 1.5 percent. The rest of the return, which is for increases in the cost of living, is added to the bond’s principal. Thus, relative to regular Treasury bonds, which pay out all their returns in interest, the inflation-indexed Treasuries pay significantly less interest. Therefore, they don’t make sense for nonretirement account investors who seek maximum income to live on.
For recommended inflation-indexed Treasury funds, please see the “Eyeing Recommended Bond Funds” section, later in this chapter. (Also know that regular bond fund managers may invest some of their fund’s assets in inflation-indexed Treasuries if they appear attractive relative to other bonds.)
Investing in Bond Funds
It’s time to get down to how and why you might use bonds. Bonds may be boring, but they can be more profitable for you than super-boring bank savings accounts and money market funds. Bonds generally pay more than these investments because they involve more risk: You’re purchasing an investment that’s intended to be held for a longer period of time than savings accounts and money market funds.
That doesn’t mean that you have to hold a bond until it matures, because an active market for them does exist. You can sell your bond to someone else in the bond market (which is exactly what a bond fund manager does if he wants out of a specific bond he holds in the bond fund). You may receive more — or less — for the bond than you paid for it depending on what has happened in the financial markets since then.
As I discuss earlier, in the section “Maturity: Counting the years until you get your principal back,” bond funds are riskier than money market funds and savings accounts because their value can fall if interest rates rise. However, bonds tend to be more stable in value than stocks (see Chapter 1).
Why you might (and might not) want to invest in bond funds
Investing in bonds is a time-honored way to earn a better rate of return on money that you don’t plan to use within at least the next couple of years. As with other mutual funds, bond funds are completely liquid on a day’s notice, but I advise you to view them as longer term investments. Because their value fluctuates, you’re more likely to lose money if you’re forced to sell the bond fund sooner rather than later. In the short term, the bond market can bounce every which way; in the longer term, you’re more likely to receive your money back with interest.
Don’t invest your emergency money in bond funds — use a money market fund instead (see Chapter 11). You could receive less money from a bond fund (and could even lose money) if you need it in an emergency.
Avoid using the check-writing option that comes with many bond funds. Every time you sell shares in a bond fund (which is what you’re doing when you write a check), this transaction must be reported on your annual income tax return. When you write a check on a money market fund, by contrast, it isn’t a so-called taxable event because a money fund has a fixed share price, so you’re not considered to be adding to or subtracting from your taxable income when you sell these shares.
You also shouldn’t put too much of your longer term investment money in bond funds (for example, your retirement money if you’re a young adult with many decades until you would retire). With the exception of those rare periods when interest rates drop significantly, bond funds won’t produce the high returns that growth-oriented investments such as stocks, real estate, and your own business can.
Here are some common financial goals to which bond funds are well suited:
A major purchase: But make sure that the purchase won’t happen for at least two years, such as the purchase of a home. Short-term bond funds should offer a higher yield than money market funds. However, bond funds are a bit riskier, which is why you should have at least two years until you need the money to allow time for recovery from a dip in your bond fund account value.
Part of a long-term, diversified portfolio: Because stocks and bonds don’t move in tandem, bonds can be a great way to hedge against declines in the stock market. In fact, in a down economic environment, bonds may appreciate in value if inflation is declining. Different types of bond funds (high-quality bonds and junk bonds, for example) typically don’t move in tandem with each other either, so they can provide an additional level of diversification. In Chapter 10, where I talk about asset allocation, I explain how to incorporate bonds into long-term portfolios for goals such as retirement.
Generating current income: If you’re retired or not working, bonds are better than most other investments for producing a current income stream.
How to pick a bond fund with an outcome you can enjoy
When comparing bond funds of a given type (for example, high-quality, short-term corporate bond funds), folks want to pick the one that’s going to make the most money for them. But be careful; some mutual fund companies exploit your desire for high returns. These fund firms love to lure you into a bond fund by emphasizing high past performance and current yield, deflecting your attention away from the best predictor of bond fund performance: operating expenses.
Don’t overemphasize past performance
A major mistake that novice bond fund investors make is to look at recent performance and assume that those are the returns they’re going to get in the future. Investing in bond funds based only on recent performance is tempting right after a period when interest rates have declined, because declines in interest rates pump up bond fund total returns. Remember that an equal but opposite force is waiting to counteract pumped-up bond returns — bond prices fall when interest rates rise, which they eventually will.
Don’t get me wrong: Past performance is an important issue to consider. But in order for performance numbers to be meaningful and useful, you must compare the same type of bond funds to each other (such as intermediate-term funds that invest exclusively in high-grade corporate bonds) and against the correct bond market index or benchmark (which I discuss in Chapter 17).
Be careful with yield quotes
A bond fund’s yield measures how much the fund is currently paying in dividends; it’s quoted as a percentage of the fund’s share price — say, 5.2 percent. This statistic certainly seems like a valid one for comparing funds. Unfortunately, some fund companies have abused it.
Don’t confuse a bond fund’s yield with its return. Dividends are just one part of a fund’s return, which also includes capital gain distributions and changes in the bond fund’s share price. Over a given period of time, a bond fund could have a positive yield but a negative overall return, particularly if interest rates have increased or the credit quality of bonds in its portfolio has deteriorated.
Some unscrupulous fund companies try to obscure the difference between yield and return. For example, consider an advertisement sent by the Fundamental U.S. Government Strategic Income Fund. In huge type on the cover of this brochure, the fund boasted of its 11.66-percent yield, an impressive number because 30-year Treasury bonds were yielding less than 8 percent at the time. One can only assume that the designers of this promo piece hoped that you wouldn’t check out the back cover, where the small print stated that the fund’s total return for the previous year was –15.7 percent.
Mutual fund companies can play a few games to fatten a fund’s yield. Such sleight of hand makes a fund’s marketing department happy because higher yields make hawking the bond funds easier for salespeople. But remember that yield-enhancing shenanigans can leave you disappointed when a bond fund fails to perform well after you buy it based on the allure of a swollen yield. Here’s what to watch out for:
Lower quality: You may compare one short-term bond fund to another and discover, for example, that one pays 0.5 percent more and, therefore, looks better. But, if you look a little further, you see that the higher yielding fund invests 20 percent of its assets in junk bonds (a BB or less credit-quality rating), whereas the other fund is fully invested in high-quality bonds (AAA and AA rated). In other words, the junk bond fund isn’t necessarily better; given the risk it’s taking, it should be yielding more.
Lengthened maturities: Bond funds can usually increase their yield just by increasing maturity a bit. (Insiders call this ploy going further out on the yield curve.) So when comparing yields on different bond funds, be sure that you’re comparing them for funds of similar maturity. Even if they both call themselves “intermediate-term,” if one bond fund invests in bonds maturing on average in seven years, while another fund is at ten years for its average maturity, comparing the two is a classic case of comparing apples to oranges. Because longer term bonds usually have higher yields (due to increased risk), the ten-year average maturity fund should yield more than the seven-year average maturity fund.
Giving your money back without your knowledge: Some funds return a portion of your principal in the form of dividends. This move artificially pumps up a fund’s yield but depresses its total return. Investors in this type of bond fund are rudely awakened when, after enjoying a healthy yield for a period of time, they examine the share price of their bond fund shares and find that they’ve declined in value.
When you compare bond funds to each other by using the information in the prospectuses (see Chapter 8), make sure that you compare their total return over time (in addition to making sure that the funds have comparable portfolios of bonds and similar durations).
Waiving of expenses: Some bond funds, particularly newer ones, waive a portion or even all of their operating expenses to temporarily inflate the fund’s yield. Yes, you can invest in a fund that’s having a sale on its operating fees, but you also have the hassle of monitoring the fund to determine when the sale is over. Bond funds engaging in expense waiving often end such sales quietly when the bond market is doing well. Don’t forget that if you sell a bond fund (held outside of a retirement account) that has appreciated in value, you owe taxes on your profits.
Do focus on costs
Like money market funds, bond fund returns are extremely sensitive to costs. After you’ve identified a particular type of bond fund to invest in, expenses — sales commissions and annual operating fees — should be your number-one criterion for comparing funds.
For bond funds, you should generally shun funds with operating expenses higher than 0.5 percent.
The marketplace for bonds is fairly efficient. For any two bond managers investing in a particular bond type — say, long-term municipal bonds — picking bonds that outperform the other’s over time is difficult. But if one of those bond funds charges lower fees than the other, that difference provides the low-fee fund with a big head start in the performance race.
You can earn a higher return from a bond fund by investing in funds that
Hold longer term bonds
Hold lower credit-quality bonds
Have lower operating expenses
Please note that the first two ways of earning a higher bond fund yield — using longer term and lower credit-quality bonds — increase the risk that you’re exposed to. Stick with no-load funds that have low annual operating expenses as a risk-free way to boost your expected bond fund returns.
How to obtain tax-free income
Just as money market funds can produce taxable or tax-free dividends (see Chapter 11), so too can bond funds. In order to produce tax-free income, a bond fund invests in municipal bonds (also called muni bonds or munis) issued by state or local governments.
As long as you live in the United States, generally, municipal bond fund dividends are federally tax-free to you. Funds that specialize in muni bonds issued just in your state pay dividend income that’s typically free of your state’s taxes as well.
When you’re investing in bonds inside retirement accounts, use taxable bonds. If you’re investing in bonds outside retirement accounts, the choice between taxable versus tax-free depends on your tax bracket. If you’re in a high tax bracket (28 percent or higher for federal) and you want to invest in bonds outside of tax-sheltered retirement accounts, you may do better in a muni fund than in a bond fund that pays taxable dividends (see Chapter 10 to determine your tax bracket).
Eyeing Recommended Bond Funds
If you’ve read through this chapter, you now know more about bond funds than you probably ever imagined possible, so now it’s time to get down to brass tacks: selecting bond funds for a variety of investing needs.
Using the logic laid out earlier in this chapter, I present you with a menu of choices. Although thousands of bond funds are available — few are left to consider after you eliminate the high-cost ones (loads and ongoing fees), low-performance funds (which are often the just-mentioned high-cost funds), and funds managed by fund companies and managers with minimal experience investing in bonds.
I’ve done the winnowing for you, and the funds I present in the sections that follow are the best of the best for meeting specific needs. I’ve organized the funds by the average maturity and duration of the bonds that they invest in, as well as by the taxability of the dividends that they pay.
Use the following funds only if you have sufficient money in your emergency reserve (see Chapter 3). If you’re investing money for longer term purposes, particularly retirement, come up with an overall plan for allocating your money among a variety of different funds, including stock and bond funds. For more on allocating your money, be sure to read Chapter 10.
Short-term bond funds
Short-term bond funds, if they live up to their name, invest in short-term bonds (which mature in a few years or less). Of all bond funds, these are the least sensitive to interest rate fluctuations. Their stability makes them the most appropriate bond funds for money on which you want to earn a better rate of return than a money market fund could produce for you. But with short-term bond funds, you also have to tolerate the risk of losing a few percent in principal value if overall interest rates rise.
Short-term bonds work well for investing money to afford major purchases that you expect to make in a few years, such as a home, a car, or a portion of your retirement account investments that you expect to tap in the near future.
Taxable short-term bond funds
Bond funds that pay taxable dividends are appropriate for nonretirement accounts if you’re not in a high tax bracket (no more than 28 percent federal) and for investing inside retirement accounts. (Call the fund companies for current yields.)
Vanguard Short-Term Investment-Grade (VFSTX) invests the bulk of its portfolio in high- and moderate-quality, short-term corporate bonds. (The average credit rating is AA.) Typically, it keeps a small portion in U.S. Treasuries. It may even stray a bit overseas and invest several percent of the fund’s assets in promising foreign bonds. This fund maintains an average maturity of two to three years, and duration currently is two years.
Robert Auwaerter has managed Vanguard’s Short-Term Corporate fund since the early 1980s. Gregory Nassour, who had been an investment manager since 1994, was added as co-manager in 2008. All told, this fund invests in more than 1,000 bonds. (Imagine having to keep track of all of them on your own!) This fund’s operating expense ratio is just 0.26 percent (0.14 percent for its Admiral share class discussed in the adjacent sidebar). It has a $3,000 minimum. (Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.) 800-662-7447.
Vanguard offers an ETF similar to this fund: Short-Term Corporate Bond ETF (VCSH). It’s expense ratio is just 0.15 percent.
U.S. Treasury short-term bond funds
U.S. Treasury bond funds are appropriate if you prefer a bond fund that invests in U.S. Treasuries (which have the safety of government backing) or if you’re not in a high federal tax bracket (no more than 28 percent), but you are in a high state tax bracket (5 percent or higher). I don’t recommend Treasuries for retirement accounts because they pay less interest than fully taxable bond funds. (Call the fund companies for current yields.)
Vanguard Short-Term Treasury (VFISX) invests in U.S. Treasuries maturing within two to three years — you can’t get much safer than that. Duration currently is two years. This fund has been managed by David Glocke since 2000, who has been an investment manager since 1991. Although the fund has that lean Vanguard expense ratio of 0.22 percent annually (0.12 percent for the Admiral share class), don’t forget that you can buy Treasuries direct from your local Federal Reserve Bank if you don’t need liquidity. The minimum initial investment is $3,000. (Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.) 800-662-7447.
Municipal tax-free short-term bond funds
Short-term bond funds that are free of both federal and state taxes are scarce. However, some good short-term funds are free of federal, but not state, taxes. These are generally appropriate if you’re in a higher federal bracket (more than 28 percent) but in a low state bracket (less than 5 percent).
If you live in a state with high taxes, consider a state money market fund, which I cover in Chapter 11. (Call the fund companies for current yields.)
Vanguard Short-Term Tax-Exempt (VWSTX) invests in the crème de la crème of the federally tax-free muni bonds issued by state and local governments around the country. (Its average credit rating is AA.) The fund’s average maturity ranges from one to two years, and duration is about one year.
Vanguard Limited-Term Tax-Exempt (VMLTX) does just what the short-term fund does (and has the same manager), except that it does it a while longer. This fund’s average muni bond matures in two to five years (with a duration of about three years), although its average credit rating is a respectable AA.
Both the short-term and limited-term funds have a miserly annual operating expense ratio of 0.20 percent and require a $3,000 minimum initial investment. Admiral shares, with a 0.12 percent expense ratio, are available for both these funds. (Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.) 800-662-7447.
Intermediate-term bond funds
Intermediate-term bond funds hold bonds that typically mature within a decade or so. They’re more volatile than shorter term bonds but should be more rewarding. The longer you can own an intermediate-term bond fund, the more likely you are to earn a higher return on it than on a short-term fund, unless interest rates keep rising over many years.
You shouldn’t purchase an intermediate-term fund unless you expect to hold it for a minimum of three to five years — or longer, if you can. Therefore, the money you put into this type of fund should be money that you don’t expect to use during that period. (Call the fund companies for current yields.)
Taxable intermediate-term bond funds
If you invest in these funds in a nonretirement account, be sure that you’re not in a high tax bracket — more than 28 percent federal.
Dodge & Cox Income (DODIX) is run by a conservative management team at an old San Francisco investment firm that has been managing money for private accounts since 1930 and running mutual funds since 1931. This fund, which focuses on government securities and high-grade corporate debt, has an average bond credit rating of AA, an average maturity of five to ten years, and a duration of about four to five years. This fund is team managed with the managers having an average tenure of about 14 years. The operating expense ratio is a reasonable 0.43 percent: $2,500 is the minimum initial investment ($1,000 for retirement accounts). 800-621-3979.
Harbor Bond (HABDX) is a more aggressive intermediate-term bond fund. The fund invests mostly in corporate bonds, as well as in mortgage bonds with average maturities of up to ten years (duration is about five years), depending on fund manager William Gross’s outlook for inflation and the economy.
Gross, who’s managed this fund since 1987, has three plus decades of experience managing money in the bond market. He makes relatively wide swings in strategy and, during periods of rising interest rates, has bulked up the fund with money market securities to protect principal. At times, Gross has also ventured small portions of the fund into foreign bonds, junk bonds, and even a sprinkling of derivatives such as futures and options to slightly leverage returns. (The fund has an average credit rating of AA.) Despite its aggressiveness, the fund has had low volatility. Although this fund’s expense ratio is a tad on the high side (0.57 percent), Gross has delivered high enough long-term returns to justify the slightly higher costs. The minimum initial investment is just $1,000. 800-422-1050.
Vanguard Total Bond Market Index (VBMFX) is an index fund that tracks the index of the entire bond market, the Lehman Brothers Aggregate Bond Index. The fund is managed Kenneth Volpert, Gregory Davis, and a computer. It uses a sampling to mirror the index so it doesn’t actually invest in every bond in the index. Investment-grade corporate bonds and mortgages make up the majority of the fund’s investments; the rest are U.S. government and agency securities. The fund’s average maturity is about seven years, with a duration of about five years. (Average bond credit rating is AA.) Annual operating expenses are a paltry 0.22 percent (0.14 percent for Admiral shares). (Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.) You need a $3,000 minimum initial investment to open. 800-662-7447.
Vanguard Total Bond Market ETF (BND) is an ETF similar to this fund. Its expense ratio is 0.14 percent.
Vanguard GNMA (VFIIX) invests in residential mortgages that people just like you take out when they purchase a home and borrow money from a bank. Like other GNMA funds, this one has very low credit risk. (Its average credit rating is AAA.) Why? Because the principal and interest on GNMAs is guaranteed by the U.S. government. All GNMA funds have prepayment risk. (If interest rates fall, mortgage holders refinance.) But this GNMA fund has less risk than most because it minimizes the purchase of mortgage bonds that were issued at higher interest rates — and are, therefore, more likely to be refinanced and paid back early.
This fund is managed by Thomas Pappas at Wellington Management, a private money management firm that Vanguard uses for some of its other funds. GNMA doesn’t invest in some of the more exotic mortgage securities and derivatives that are abused by other firms’ bond funds. Like all other bond funds, this one has interest rate risk, though it’s comparable to other intermediate-term bond funds despite the longer maturity of most of this fund’s holdings. Duration is generally around four years, and the fund’s yearly operating expense ratio is 0.23 percent: $3,000 is the minimum initial investment. (Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.) 800-662-7447.
Vanguard Mortgage-Backed Securities ETF (VMBS) is an ETF similar to this fund. Its operating expense ratio is 0.15 percent.
Vanguard High Yield Corporate (VWEHX) invests in lower quality (junk) corporate bonds. These pay more and are for more aggressive investors stretching for greater yield. Intermediate-term junk bonds are volatile: They not only are interest rate sensitive, but also they’re susceptible to changes in the economy. For example, this fund lost more than 10 percent of its principal value in 1989, 1990, and 1994 and more than 25 percent in 2008. (Dividends payments, of course, mitigated some of this principal erosion.)
Unlike other high-yield funds, this fund invests little (if any) of its funds in lower rated junk bonds; it invests in the best of the junk (its average credit rating is BB). The average maturity of this fund is seven years, with a duration of five years. Michael Hong, who has been an investment manager since 1997, at Wellington Management has managed this fund since 2008. The fund has been around since 1978 — a degree of longevity that makes it one of the longest and best-performing junk bond funds. Yearly operating expenses are 0.32 percent: $3,000 is the minimum initial investment. (Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.) 800-662-7447.
U.S. Treasury intermediate-term bond funds
U.S. Treasury bond funds are appropriate if you prefer a bond fund that invests in U.S. Treasuries (which have the safety of government backing) and if you’re not in a high federal tax bracket (no more than 28 percent), but you are in a high state tax bracket (5 percent or higher). I don’t recommend Treasuries for retirement accounts because they pay less interest than fully taxable bond funds. (Call the fund company for current yields.)
Vanguard Intermediate-Term Treasury (VFITX) invests in U.S. Treasuries maturing in five to ten years. (See the description for the short-term U.S. Treasury funds for minimum initial investment and expense ratio.) 800-662-7447.
Vanguard Inflation-Protected Securities (VIPSX) fund is a new breed of fund, which I cover in the “Inflation-indexed Treasury bonds” section in this chapter. With a low operating expense ratio of 0.25 percent (0.12 for the Admiral share class), this fund is a good one for inflation-skittish investors to consider. It has a $3,000 minimum initial investment. (Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.) 800-662-7447.
Municipal tax-free intermediate-term bond funds
Consider federally tax-free bond funds if you’re in a high federal bracket (28 percent and up) but a relatively low state bracket (less than 5 percent). (Call the fund company for current yields.)
If you’re in the market for a state and federally tax-free bond fund, the problem is that the ones available (and there aren’t all that many) have high expenses. High expenses are always a problem but are especially so in a low interest rate environment (like has been around for years) because little of a fund’s yield will be left to pay out. So, if you’re in high federal (28 percent and up) and high state (5 percent or higher) tax brackets, you’re better off using the nationwide Vanguard municipal bond fund that I describe at the end of this section.
Fidelity Intermediate Municipal Income (FLTMX) invests in high-credit-quality (average rating is A) municipal bonds that generally mature within ten years. This fund’s average maturity is usually around eight years, with a duration of about five to six years. The expense ratio is a competitive 0.38 percent, and the minimum initial investment is $10,000. 800-544-8888.
Vanguard Intermediate-Term Tax-Exempt (VWITX) does what Vanguard’s short-term muni funds do, except that it invests in slightly longer term muni bonds. (Duration is generally about six years, and the average credit rating is AA.) The annual operating expense ratio is a mere 0.20 percent (0.12 for the Admiral share class); $3,000 is the minimum initial investment. Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee. 800-662-7447.
Long-term bond funds
Long-term bond funds are the most aggressive and volatile bond funds around. If interest rates on long-term bonds increase substantially, the principal value of your investment could decline 10 percent or more.
Long-term bond funds generally are used for retirement investing in one of two situations:
For investors not expecting to tap their investment money — ideally — for a decade or more
For investors wanting to maximize current dividend income and who are willing to tolerate volatility
Don’t use these funds for investing money that you plan to use within the next five years, because a bond market drop could leave your portfolio with a bit of a hangover. (Use intermediate-term and short-term bond funds instead.) And don’t use the taxable funds in a nonretirement account if you’re in a high tax bracket — especially higher than 28 percent federal. (Call the fund companies for current yields.)
Taxable long-term bond funds
Bond funds that pay taxable dividends are appropriate for nonretirement accounts if you’re not in a high tax bracket (no more than 28 percent federal) and for investing inside retirement accounts. (Call the fund companies for current yields.)
Vanguard Long-Term Investment-Grade (VWESX) is comprised mostly of high-grade corporate bonds, but it sometimes holds around 10 percent in Treasuries and foreign and convertible bonds. (Average credit rating is A.) Long-term bonds such as these (the fund’s average maturity is 20+ years, with a duration of 10+ years) can produce wide swings in volatility. For example, this fund lost more than 12 percent of its principal value in 1999, its worst year in a generation. The dividends of 6.3 percent paid that year brought the fund back to produce a total return of –6.2 percent. Wellington Management’s Lucius Hill has managed the fund since 2008, and he has been an investment manager since 1993. Wellington itself has managed this fund since its inception in 1973. It has an annual operating expense ratio of 0.28 percent (0.16 percent for Admiral shares), with a $3,000 minimum initial investment. (Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee.) 800-662-7447.
An ETF version of this fund is available and is called Vanguard Long-Term Corporate Bond ETF (VCLT). Its expense ratio is 0.15 percent.
U.S. Treasury long-term bond funds
U.S. Treasury bond funds are appropriate if you prefer a bond fund that invests in U.S. Treasuries (which have the safety of government backing) and if you’re not in a high federal tax bracket (no more than 28 percent), but you are in a high state tax bracket (5 percent or higher). I don’t recommend Treasuries for retirement accounts because they pay less interest than fully taxable bond funds. (Call the fund companies for current yields.)
Vanguard Long-Term Treasury (VUSTX) invests in U.S. Treasuries with average maturities around 20 years. Duration is about 12 years. (See the description in the section “U.S. Treasury short-term bond funds” for minimum initial investment and expense ratio.) Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee. 800-662-7447.
Municipal tax-free long-term bond funds
Consider federally tax-free bond funds if you’re in a high federal bracket (28 percent and up) but a relatively low state bracket (less than 5 percent). (Call the fund company for current yields.)
Vanguard Long-Term Tax-Exempt (VWLTX) does what Vanguard’s short-term muni funds do, except that it invests in long-term muni bonds. (The average credit rating is AA.) This fund has an operating expense ratio of 0.20 percent. This fund has a $3,000 minimum initial investment. Investors are advised to keep at least $10,000 in this fund or register their accounts at Vanguard’s Web site for electronic delivery of statements and fund reports; otherwise, you pay a $20 annual fee. 800-662-7447.
State and federally tax-free bond funds may be appropriate if you’re in high federal (28 percent and up) and high state (5 percent or higher) tax brackets. The fund providers Fidelity, T. Rowe Price, and Vanguard offer competitive funds for states such as California, Connecticut, Florida, Maine, Maryland, Michigan, Minnesota, New Jersey, New York, Ohio, and Pennsylvania. If you can’t find a good state-specific bond fund for your state, or if you’re only in a high federal tax bracket, use the nationwide Vanguard Municipal bond funds I describe in this section. (Call the fund companies for current yields.)
Exploring Alternatives to Bond Funds
Bond mutual funds are just one way to lend your money and get paid a decent yield. In the following sections, I discuss the advantages and disadvantages of other alternatives, some of which have acronyms that you can impress your friends and family with — or confirm that you’re an investments geek. Regardless of which investment type(s) you end up purchasing, do your big-picture thinking first: What do you plan to use the money for down the road? How much risk are you willing and able to take? What’s your tax situation?
Most of these bond fund alternatives have one thing in common: They offer psychological solace to those who can’t stomach fluctuations in the value of their investments. After I tell you more about these alternatives (including information that you’re not likely to hear in a marketing pitch from the company or person who’s trying to sell you on them), low-cost bond funds may look more attractive.
Certificates of deposit
For many decades, bank certificates of deposit (CDs) have been the safe investment of choice for folks with some extra cash that they don’t need in the near term. The attraction is that you get a higher rate of return on a CD than on a bank savings account or money market fund. And unlike a bond fund, a CD’s principal value doesn’t fluctuate. Of course, you also enjoy the peace of mind afforded by the government’s FDIC insurance program.
All these advantages of CDs aren’t nearly as attractive as they may seem on the surface. I start with the FDIC insurance issue. Bonds and bond mutual funds aren’t FDIC-insured. The lack of this insurance, however, shouldn’t trouble you on high-quality bonds because these bonds rarely default. Even if a fund held a bond that defaulted, it probably would be a tiny fraction (less than 1 percent) of the value of the fund, so it would have little overall impact.
You may believe that there’s no chance you’ll lose money on a CD — but banks have failed and will continue to fail. Although you’re insured for $100,000 in a bank, if the bank crashes, you’ll likely wait a while to get your money back — and you’ll probably have to settle for less interest than you expected, too.
Here’s another myth about CDs: The principal value of your CD doesn’t fluctuate. Sure it does; you just don’t see the fluctuations! Just as the market value of a bond drops when interest rates rise, so too does the “market value” of a CD — and for the same reasons. At higher interest rates, investors expect a discounted price on fixed-interest-rate CDs because they always have the alternative of purchasing a new CD at the higher prevailing rates. Some CDs are actually bought and sold among investors — on what’s known as a secondary market — and they trade and behave just like bonds.
So a lot of those advantages CDs seem to have aren’t as impressive as some may believe. In fact, compared to bonds, CDs have a number of drawbacks:
Early withdrawal penalties: Money in a CD isn’t accessible unless you pay a fairly big penalty — typically, six months’ interest. With a no-load (commission-free) bond fund, if you need some or all of your money next month, next week, or even tomorrow, you can access it without penalty.
Restricted tax options: Another seldom-noted drawback of CDs is that they come in only one tax flavor — taxable. Bonds, on the other hand, come both in tax-free (federal and/or state) and taxable flavors. So if you’re a higher tax-bracket investor, bonds offer you tax-friendly options that CDs can’t.
Lower yield: For a comparable maturity, CDs yield less than a high-quality bond. Often, the yield difference is 1 percent or more. If you don’t shop around — if you lazily purchase CDs from the bank that you use for your checking account, for example — you may be sacrificing 2 percent or more in yield.
Don’t forget about the unfriendly forces of inflation and taxes. They may gobble up all the yield that your CD is paying, thus leaving you no real growth on your investment. An extra percentage point or two from a bond can make a big difference in the long term.
You’ll earn more over the years and have better access to your money in bond funds than in CDs. And bond funds make particular sense if you’re in a higher tax bracket and would benefit from tax-free income on your investments. If you’re not in a high tax bracket and you get gloomy whenever your bond fund’s value dips, then consider CDs.
CDs may make the most sense if you know, for example, that you can invest your money for one year, after which you’ll need the money for some purchase you expect to make. Just make sure that you shop around to get the best interest rate. If what attracts you to CDs is the U.S. government backing that comes with FDIC insurance, consider Treasuries, which are government-backed bonds. Treasuries often pay more interest than the better CDs available.
Individual bonds
Maybe you’ve had thoughts like these:
Why buy a bond fund and pay all those ongoing management fees, year after year, when I can buy high-rated bonds that pay a higher yield than that fund I’m looking at?
I can create my own portfolio of bonds and purchase bonds with different maturities. That way, I’m not gambling on where interest rates are headed, and I won’t lose principal as I may in a bond fund.
Or more likely, you’ve listened to a broker — who was trying to sell individual bonds to you — make these sorts of remarks. Does the purchase of individual bonds make sense for you? Although the decision depends on several factors, I can safely say that most types of individual bonds probably are not for you. (Treasuries that you can buy directly from a local Federal Reserve Bank without charge are notable exceptions to my comments that follow.)
Here are some solid reasons why a good bond mutual fund beats individual bonds:
Mutual funds allow for better diversification. You don’t want to put all your investment money into a small number of bonds of companies in the same industry or that mature at the same time. Building a diversified bond portfolio with individual issues is difficult unless you have a hefty chunk (at least several hundred thousand dollars) that you desire to invest in bonds.
You want to save on commissions. If you purchase individual bonds through a broker, you’re going to pay a commission. In most cases, it’s hidden; the broker quotes you a bond price that includes the commission. Even if you go through a discount broker, transaction fees take a healthy bite out of your investment. The smaller the amount invested, the bigger the bite. On a $1,000 bond, the fee can equal up to 5 percent.
Adjusting bond holdings as percentage of your portfolio is easy. Good investment management includes monitoring and adjusting your overall bond/stock mix. Adding to or subtracting from your bond holdings by using individual bonds, however, can be inconvenient and costly.
Life’s too short. Do you really want to research bonds? You have better things to do with your time. Bonds and the companies that stand behind them aren’t that simple to understand. For example, did you know that some bonds can be “called” before their maturity date? Companies often do this to save money if interest rates drop significantly. After you purchase a bond, you need to do the same things that a good bond fund manager would need to do, such as tracking the issuer’s creditworthiness and monitoring other important financial developments.
In terms of costs, you can purchase terrific bond funds with yearly operating expense ratios of just 0.2 percent (or less). And remember, a bond mutual fund provides you tons of diversification and professional management so that you can spend your time doing activities you’re good at and enjoy. You can increase your diversification by purchasing bond funds with different maturity objectives (short, intermediate, and long) or an index bond fund that covers the range.
If you already own individual bonds and they fit your financial objectives and tax situation, you can hold them until maturity because you’ve already incurred a commission (which some brokers instead call a markup) when they were purchased; selling them now would just create an additional fee. When the bond(s) mature(s), think about moving the proceeds into bond funds if you want to continue owning bonds.
Don’t mistakenly think that your current individual bonds are paying the same yield as when they were originally issued. (That yield is the number listed on your brokerage account statement in the name of the bond.) As the market level of interest rates changes, the actual yield of your bonds fluctuates to rise and fall with the market level of rates. So if rates have fallen since you bought your bonds, the value of those bonds has increased — which in turn reduces the effective yield that you’re currently earning.
Guaranteed-investment contracts
Guaranteed-investment contracts (GICs) are sold and backed by an insurance company. Typically, they quote you a rate of return projected one or a few years forward. So, like that of a CD, a GIC’s return is always positive and certain. With a GIC, you experience none of the uncertainty that you normally face with a bond fund that fluctuates in value with changing interest rates and other economic upheavals.
The attraction of GICs is that your account value doesn’t fluctuate (at least, not that you can see). For people who panic the moment a bond fund’s value slips, GICs soothe the nerves. And they usually provide a higher yield than a money market or savings account.
As a rule, the insurance company invests GIC money mostly in bonds and usually a small portion in stocks. The difference between the amount these investments generate for the insurer and the amount they pay in interest is profit to the insurer. The yield is usually comparable to that of a bond fund. Typically, once a year, you’ll receive a new statement showing that your GIC is worth more — thanks to the newly added interest.
Some employers offer GICs in their retirement savings plans as a butt-covering option or because an insurance company is involved in the company’s retirement plan. More and more companies are eliminating GICs as investment options because of the greater awareness about GICs’ drawbacks. First, insurance companies (like banks) have failed and will continue to fail. Although failed insurers almost always get bailed out — usually through a merger into a healthy company — you can take a haircut on the promised interest rate if your GIC is with a failed insurance company. Second, by having a return guaranteed in advance, you pay for the peace of mind in the form of lower long-term returns.
Mortgages
Another way that you can invest your money for greater dividend income is to lend your money via mortgages and second mortgages. Mortgage brokers often arrange these “deals.” They appeal to investors who don’t like the volatility of the stock and bond markets. With a mortgage, you don’t have to look up the value every day in the newspaper; a mortgage seems safer because you can’t watch your principal fluctuate in value.
What’s amazing is that people who invest in these types of mortgages don’t realize that they’re getting a relatively high interest rate only because they are accepting relatively high risk. The risk is that the borrower can default, which would leave you holding the bag. More specifically, you could get stuck with a property that you may need to foreclose on. And if you don’t hold the first mortgage, you’re not first in line with a claim on the property.
If a property buyer could obtain a mortgage through a conventional bank, he would. Banks offer the lowest interest rates. So if a mortgage broker is offering you a deal to lend your money at 12 percent when the going bank rate is, say, 8 percent, that means you’ll be lending money to people who the bank considers high risk. If a bank, with its vast assets on hand, isn’t willing to lend money to somebody, ask yourself whether you should. Mortgage investments also carry interest rate risk: If you need to “sell” the mortgage early, you’ll probably have to discount it, perhaps substantially if interest rates have increased since you purchased it.
If you’re willing to lend your money to borrowers who carry a relatively high risk of defaulting, check out high-yield bond funds, which I discuss earlier in the chapter (under “Taxable intermediate-term bond funds”). With such funds, you at least diversify your money across many borrowers, and you benefit from the professional review and due diligence of the fund management team. If the normal volatility of a bond fund’s principal value makes you queasy, then don’t follow your investments so closely!
When you’re selling some real estate and are willing to act as the bank and provide the financing to the buyer in the form of a first mortgage, consider that a viable investment. Be careful to check the borrower’s credit, employment, and income situation; get a large down payment (at least 20 percent); and try not to lend so much money that it represents more than, say, 10 percent of your total investments.
Exchange-traded bond funds
In 2007, Vanguard launched four different bond ETFs:
Total bond market ETF
Short-term bond ETF
Intermediate-term bond ETF
Long-term bond ETF
These funds track respective Lehman Brothers bond indexes. The expense ratio of these new ETFs is 0.11 percent. Check out Chapter 5 for more information on ETFs.