Why it’s still smart to own bond mutual funds

If you’re invested in bond mutual funds, relax. The Great Bond Collapse, touted by so many noisy commentators last month, has been put on indefinite hold. Fears of ramped up inflation and spikes in interest rates were premature. Bond funds still look like sound investments, for income and diversification.

So make yourself a hot cup of herbal tea to calm your nerves and read the answers to your bond fund questions here:

Jane, the Federal Reserve is printing money. How can you say that high inflation won’t follow? You’ll be surprised to learn that the Fed is not printing money, although scaremongers love to say so. The money supply grew only 3.1 percent over the past 12 months, compared with a 110-year average of 6.6 percent, says Lacy Hunt, chief economist of the Hoisington Investment Management Company, which runs the Wasatch-Hoisington U.S. Treasury Fund. You can’t make high inflation out of that.

Inflation fears hit the headlines because the Fed decided to push new reserves into the banking system to assist the recovery (“quantitative easing,” or QE2). Interest rates rose at the end of last year, and bond prices fell.

But reserves don’t become “money” until they’re turned into customer deposits and loans, which isn’t happening. The banks are hanging on to those funds to bolster their weak capital position (they’re still writing off bad loans). If economic growth accelerates, the Fed can siphon any excess reserves out of the system. “People have overreacted,” says Gus Sauter, chief investment officer of The Vanguard Group of mutual funds. “We don’t see the return of high inflation yet.”

Business improved last year and we got a tax cut. Doesn’t that mean a stronger economy and higher interest rates in 2011? Two things drive interest rates up: expectations of higher inflation, which roiled the market at the end of last year, and an increase in economic activity. But it’s far from clear that stronger growth is in the cards. The so-called “tax cut” simply kept income tax rates where they were last year, without adding any stimulus. Half of the two-point cut in the Social Security tax (to 4.2 percent, from 6.2 percent) was offset by ending the tax credit called Making Work Pay. So it won’t add as much spending to the economy as you might think.

What’s more, home prices keep falling. We’re still losing full-time jobs; the gains are in part-time jobs. The 12-month increase in average hourly earnings fell to a cyclical low of 1.6 percent in November. State and local governments are cutting spending, raising taxes, and laying off workers. The recent rise in food and fuel prices (gasoline averages more than $3 at the pump) amount to a tax on consumers. Shoppers financed their Christmas spree by reducing their personal savings – the savings rate fell to 5.3 percent from 6.3 percent. Instead of spending even more, families are likely to pay their bills and build their savings back up.

Jane, what if you’re wrong? My bond fund lost money last month and will lose more if interest rates keep going up. Even if I’m wrong (and it wouldn’t be the first time), bond funds are still a good investment for people who buy them for income. Your fund manager would be buying the newer, higher-rate bonds and passing the extra income along to you. If you reinvest the income, you’d be buying more shares in your fund at a lower price. When the business cycle turned again, and interest rates declined, those extra shares would pop in price.

Wouldn’t it be smarter to switch to shorter-term bond funds? Not in my opinion. The yield curve is very steep right now, meaning that long-term rates are substantially higher than short-term rates. When the economy starts to move, short-term rates could rise fast, making these funds potentially more volatile than you think. At today’s low short-term rates, you’re not being compensated for that risk. Hunt is sticking with long bonds for his Wasatch fund (it returned 10.2 percent last year).

What about the risks of meltdown in the municipal bond market? Also overblown. As I wrote in a previous column, there are plenty of good muni credits available. Long-term, AA-rated muni bonds can be found at 4.8 percent, for tax-equivalent yields of 7 to 7.5 percent, depending on your tax bracket. Even the risky states are likely to pay. Debt service isn’t a major part of state budgets but it’s a crucial one. If they defaulted, they’d be shut out of the market and couldn’t raise essential funds.

Should I switch to individual bonds, to avoid the volatility of mutual funds? I still like bond funds. Individual bonds lose money, too, if interest rates rise – you just don’t see it. But you’ll feel the loss if you have to sell. The cost of investing in individual bonds in the retail market could be 2 percent or more, Sauter says (dealers often buy bonds at 98 cents on the dollar and sell them to you at 100 cents). Also, small investors take a price haircut if they sell before maturity. Low-cost bond funds are cheaper, more liquid, and better diversified. But, hey, different strokes for different folks.

Read more:

6 Safe Ways of Investing in Tax-Free Municipal Bonds

5 great money ideas for 2011

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10 comments
Jane // 01/09/2011 at 2:23 pm

I got a nice note from John Woerth at Vanguard about this post. Thanks, John and Fran.

Jane:

Fran Kinniry [http://bit.ly/eQ3jk0] in our Investment Strategy Group called me this morning to tell me that he thought your piece on bonds was the most well-done and thoughtful article on the topic that he’s seen. I told him that I wasn’t surprised. Thanks for providing some much needed perspective to investors, as always.

Regards,

John

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jim harless // 01/12/2011 at 9:42 am

Jane, now that we have ETF we can buy and sell almost like indiv. company stocks, if a person feels they know if market is going up or down, but not as good at is market given company going to go up or down, can one buy and sell , daily if desired, ETF like , for example, as one, Vanguard Total stock mk, as VTI, or is there a barrier, other than the argument against timing the market? I know with most mutual funds not only is the fee high, most discourage selling within 60 days, or some restrictive time barrier, in addition to a high buy/ sell fee? So, if a person is so inclined, is something like a ETF like VTI a possible buy sell in a day or few days? ( I realize this is not likely to be a well received question, but now we have ETFs , I have to ask….)

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Jane // 01/17/2011 at 4:13 pm

If you want to trade the market, guessing when stocks will rise or fall, yes, you want an ETF. That’s what it’s for. You won’t be surprised to hear me say that gambling on market moves isn’t the way to wealth!

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Barbara // 01/16/2011 at 5:38 pm

Jane-
In your book “Making the Most of Your Money Now” you suggested buying individual bonds and holding them to term. In this blog you said you favor bond funds. I’m confused. Also, how does buying bond funds help with income when Vanguard funds, for example, only pay a dividend at the end of the year. Thanks.

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Jane // 01/17/2011 at 4:09 pm

In my book, I discuss the pros and cons of owning individual bonds and of owning bond mutual funds, and suggest why people might want to buy one rather than the other. Funds are for people who want flexibility as well as income. Individual bonds are for people who demand certainty and know for sure that they can hold their bonds to maturity. My book is a comprehensive look at personal finance, including all types of investments and how to use them.

As for income, almost all the Vanguard bond funds pay income monthly, not annually. Equity funds pay dividends annually.

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Barbara Bejna // 02/16/2011 at 12:42 pm

Hi. I own a small amount of Vanguard GMAC shares and, since they did very well last year, I was thinking about buying $15,000 more. Then I looked at my account information and saw that the share price has gone down so far this year. Good for me as a buyer. But what is the outlook for the next year or two. I need for my money to be pretty safe. Thanks, Barbara

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Cullen // 04/11/2011 at 3:44 pm

I bought the Vanguard Short Term Treasury Bond VFISX back in August 3, 2010. I have not seen this fund go into the black for over six months and I am down about 1.66%. I am tempted to take the loss and move to stocks, however would it be expected that when a new market correction occurs in stocks that I would see the bonds rebound for a better exit.

Also I have six ETFs that are up over 30%, I have placed trailing stops of 7.5% to avoid getting booted at small market corrections. Is this a sound idea or is it okay to take the profits which in some cases are as high as 40% and wait for a market correction to re-enter the position. My general strategy is to buy and hold but I struggle with seeing positions up over 30% and not locking in when it seems too good to be true!

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Jane // 04/11/2011 at 11:53 pm

I understand wanting to take profits when ETFs are up 30-40%. Why not? The next thing is to decide where to put the proceeds of the sale. As for moving money from short-term bonds to stocks — that makes me think you don’t have a real investment plan. What’s your asset allocation? Short-term Treasuries would be for money you might need pretty soon — regardless of where interest rates go. Medium-term bonds are for income and for safety if stocks collapse. Stocks are for long-term growth. Align your investments with your objectives. Incidentally, short-term rates have been held extremely low by the Fed. As the market returns to normal, they will probably rise faster than long-term rates,

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jim harless // 09/05/2012 at 5:18 pm

we are heading into end of 2012, so what bond funds still seem good options for today? I am puzzled, since bond price and stock supposed to run opposite of one another, but right now a lot of bond mutual funds and stock prices both UP and at all time high for past several years, what does that tell us on bond investing?

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Jane // 09/11/2012 at 11:42 am

Bond prices and stock prices often move in the same direction. it happens when policy or a slow economy keeps interest rates down, while stock investors expect the economy to improve

Reply
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