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.
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;
- Coupon payment (similar to interest payments)
- 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