Reader Question; Should I Invest in a Bond Fund Now?

By in Bond, Investing | 15 comments

Many readers, especially those recipients of my Wealth Tips Newsletter write in with money questions. Recently a reader asked What to do with Retirement Funds When I Switch Jobs?

Today, SN wrote in asking about investing in bond funds. This is a really important topic right now.

Dear Barb,

While re-reading your simple but powerful book – 20 Minute Guide to Investing (free when you sign up for Wealth Tips Newsletter)– I came across the list of Bond Index Mutual Funds. For the last few weeks, I have been thinking about and researching different options of investing in a bond fund, and so the list was quite handy and timely.

My current overall portfolio asset allocation has grown lopsided over the last two years, and is skewed more toward equities – 90% equities and 10% bonds. My target asset allocation was 80% stocks and 20% bonds. To get back to my target allocation, I am not planning to sell off my equity portion; instead, I am planning to direct my new cash toward bond/bond fund purchases.

It’s with this backdrop that I am planning to direct my Roth IRA contribution of $5,000.00 toward the purchase of a bond fund. As I already have a total bond fund in my account, I am considering buying inflation protected securities, i.e., Vanguard Inflation Protected Securities Index (VIPSX), as recommended in the guide.

I’m not sure what I should do at this stage, and so would like to seek your
expert advice. SN

Bond Characteristics and Interest Rates

Bear with me while I switch on my “professor” hat. A basic characteristic of bond investing is that when interest rates fall, bond prices rise. Conversely, when interest rates rise, bond prices fall. As any savings account owner realizes, interest rates are now at an all time low. Thus, when interest rates rise, the direction of any bond fund’s net asset value is down.

Bond returns consist of two parts;

  1. Coupon payment (similar to interest payments)
  2. Price appreciation or depreciation

For example, buy an individual bond and hold it until maturity, your total return consists of the coupon payments and the return of the principal purchase price. Unless the bond issuer defaults, you are promised the coupon payments and return of principal. Although while you hold the bond, the actual “price” may go up and down, if held to maturity you won’t lose any principal value. If you sell before maturity, you might garner a capital gain or loss.

Bond Funds versus Individual Bonds

Buy a bond fund and there is no end date like with an individual bond.  For example, buy ABC Bond fund today for $10.00 per share. At the time of purchase the fund pays dividends of 3% per year or $0.30 per share. But here’s the difference, if interest rates RISE, the price for the bond fund will FALL. Thus, assume interest rates go up a percent or two over the next few years, the bond fund price will most likely decline from $10.00 to a lower price. You will experience a LOSS when you sell the fund.

So, if you buy a BOND FUND when interest rates are very low, when interest rates rise and the bond fund price falls, you will experience a loss on your initial funds when you sell since there is no end or maturity to a bond fund!

To Invest or Not in Bond Funds?

Currently, I am not investing in any bond funds. For the “bond” portion of a portfolio I would recommend buying individual Treasury Inflation Protected Securities (TIPS) or Government I Bonds. These are the same investments that are included in the Vanguard Inflation Protected Securities Index (VIPSX) fund you mentioned in your question. The only difference is that when you buy the individual bonds, you can hold them until maturity thereby avoiding the decline in principal value as interest rates rise.

How does the TIPS investment work?

  • With TIPS, the interest rate is set at the purchase date. It always stays the same. Today (November, 2013), the interest rate on the 10 year TIP is 0.375%.
  • PRINCIPAL value of the investment goes up and down with the inflation rate.
  • When the principal increases (decreases) you will get a LARGER (smaller) interest payment on the new principal amount.
  • When the TIPS security matures, you get the either the inflation adjusted value or the original principal amount; At maturity, you never get a smaller principal (as you might with a bond fund).

Buy TIPS directly from the government at TreasuryDirect.gov.

If you are looking to fund the bond or fixed portion of your asset allocation, buying TIPS will ensure that your funds match the inflation rate thereby preserving your principal contribution and matching future increases in inflation to preserve your money’s purchasing power.

Caveat: All but the shortest maturity bond funds today will decline in value when interest rates rise. 

If you have a personal finance or investing related question, write in and it will be considered for a future column.

How are you funding the fixed portion of your portfolio today?

image credit; chicken tender

a version of this article was previously published

    15 Comments

  1. Excellent advice Barb! I’m wary of buying bonds considering the low interest rates and going by what the feds said, rates won’t be raised till 2013. Not the best time to buy bonds. Buying individual bonds on the other hand requires a large amount of capital and may not be feasible for the individual investor.

    Buying TIPS is an excellent suggestion.

    Moneycone

    November 30, 2011

  2. Good suggestion on TIPS. In the limited-options portion of my 401K, TIPS is one of my allocations.

    101 Centavos

    December 1, 2011

  3. A portion of my portfolio is in VIPSX with a 13% YTD. Not bad in this market and so called low inflation!

    krantcents

    December 1, 2011

  4. Thanks for the explanation. I’ll keep VIPSX in mind. My 10% bond fund allocation is in a fixed company contribution and a target date fund that I can’t touch. 10% is good enough for now, but when I need more I’ll look at VIPSX.

    retirebyforty

    December 1, 2011

  5. @Moneycone, It’s not a bad idea to hold some cash too. Interest rates are bound to rise in 12-18 months, the opportunity cost isn’t that great and is certainly preferable to buying a bond fund and watching the principal erode.
    @101-good decision on your part!
    @Krantcents-Nice return.
    @Retire-Sounds like you are thinking your decisions through and have a sound plan!

    Barb

    December 1, 2011

  6. Thanks for the advice. I have an automatic allocation in my retirement funds (I love auto-pilot for right now). It ensures a decent return and I don’t have to fuss over the details. If I get more hands on, I have lots of people to turn to for advice – yours is on my list (obviously). 🙂

    20's Finances

    December 2, 2011

  7. I have a small portion of my portfolio in a bond fund. I think it is important to keep fixed income as a long term part of your portfolio, particularly if you are looking at income generation.

    You make a good point about TIPS and inflation risk, but when I buy a bond fund it is for the long haul. I am not interested in a short term gain or loss.

    Eric

    December 2, 2011

  8. Great advice Barb! I will certainly consider this the next time I am bolstering the “bond” portion of my portfolio. This is definitely a helpful post.

    Roshawn @ Watson Inc

    December 2, 2011

  9. @20’s-Auto allocation is great for those retirement funds. Set it and forget it :). Sounds like you are doing just great.
    @Eric-Over time, as long as you continue to reinvest dividends, you will be fine. You are wise to get started investing while you are young. Chance for great returns in the long term.
    @Roshawn-Glad to help.

    Barb

    December 2, 2011

  10. I like your TIPS suggestion. Even if rates decline in the near term, 1 or 2 years out they’re heading higher. I don’t see bond funds performing very well once that happens.

    JP @ Novel Investor

    December 3, 2011

  11. Hi JP-Only the shortest term bond funds will possibly not decline too much when interest rates go up.

    Barb

    December 4, 2011

  12. Wow. These are great investment tips. So generous of you to share this to us. Thanks a lot! I can sure use these.

    Andrew

    prime lending dallas

    December 18, 2011

  13. I feel so much more informed after reading this article! Portfolio assets have been a conundrum to me while I consider how to take the leap forward with my finances.. You managed to simplify it and provide insight on whether bonds are currently a good investment. I now understand that investing in bonds at this moment is not the best allocation of my savings. Very glad I read this.

    Barb, you are a financial magician!

    Ronnie @ All the Frugal Ladies

    November 25, 2013

  14. I’ve been hearing that the Bond Bubble is about to bust, I’m not sure how much to read into these prophesies about doom and gloom. I think the best way is to have a diversified portfolio so if one area suffers others can make things better. Currently I’m invested in index funds, bond funds, peer to peer lending and dividend stocks. Great post Barbara, keep them coming.

    Shobir @ Find Some Money

    November 26, 2013

  15. Ronnie, Thank you for the kind words. Investing takes a bit of study and exposure to understand and I’m glad I could help. May I quote your high praise (with attribution of course) in the future?
    Shobir, If there is a “magic bullet” in investing, it is diversification. It lowers one’s volatility and boosts returns in the long term.

    Barbara Friedberg

    November 26, 2013

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