If you have bond funds in your portfolio, you probably feel the same way: Sooner or later, interest rates will rise, and the value of your bond funds will fall. Perhaps you should start replacing those bond funds with something virtually guaranteed to go up: money funds.
A mix of bonds and stocks — typically 60% stocks and 40% bonds — is a staple of the investment diet. It's the baseline allocation for balanced funds, and it generally makes a great deal of sense. Stock prices rise when the economy rallies; bond prices rise when the economy falls.
Most times, the strategy works just fine. The past 10 years, the average balanced fund has earned an average 3% a year vs. -0.4% for the Standard & Poor's 500-stock index and 2.2% for the average money market fund.
The 60%/40% stock-bond split isn't etched in stone. People generally adjust the mixture according to their age or risk tolerance. But most people have at least some bond funds in their portfolios, particularly their 401(k) plans.
So why would your bond position make you feel edgy? For one thing, bond yields are close to their lowest levels ever. And that means that bond prices are at their highest ever.
Bond prices fall when interest rates rise, and vice versa. Suppose we woke up tomorrow and interest rates had risen by 1 percentage point. The price of the current five-year T-note would fall about 4.7%, says Terry Moore, fixed income specialist for T. Rowe Price. If rates rose 3 percentage points, the five-year T-note would fall 13.4%.
Rates won't rise that much overnight. But bonds have been in a bull market since September 1981, when five-year T-notes yielded an astonishing 16.2%.
The bull could continue for a while as the Federal Reserve buys T-notes on the open market, a move it announced Wednesday.
But consider this: The five-year T-note yield has averaged 5% the past 20 years. It yields 1.02% now — its lowest ever. Even if rates were to return to average, you could take significant losses on your bond fund.
Fortunately, you'll have a fair amount of time before rates start to go up again. Interest rates rise when the economy gains steam and demand for loans picks up. There's no danger of that anytime soon.
A simple solution for 401(k) investors would be to put new money into your plan's money market account. The interest you get from money funds these days wouldn't fill an ant's thimble: The average fund yields just 0.03%, according to iMoneyNet.
On the other hand, money fund yields have nowhere to go but up. And as the economy starts to recover, the Fed will start pushing up short-term interest rates.
You can boost your yield somewhat with these investments:
•Guaranteed investment contracts. These insurance-backed investments are available only to 401(k) investors and typically yield a bit more than money market funds.
•Short-term bond ladders. You lose money in a Treasury bond only if you sell it before it matures. If you buy two-year T-notes every quarter, you'll be able to reinvest your maturing bonds at higher rates.
•Ultrashort bond funds. These buy bonds that mature, on average, in one year or less. They can pay considerably more than money funds — about 1.5%, according to Morningstar.
A word of warning about ultrashort funds. Normally, short-term bonds suffer less than long-term bonds when interest rates rise.
But short-term bond funds are mutual funds, and their holdings can vary considerably — as can their records. The Schwab YieldPlus fund, for example, managed to lose 35% in 2008, including reinvested income. Schwab settled a class-action lawsuit against the fund in April for $200 million.
Look for a fund with a decent track record and reasonably high-quality holdings.
Most important, look for an ultrashort fund with low expenses. If your fund is earning 2% from its investments and charging 1% in expenses, you're giving away half your return to management.
And that should send shivers up your spine.
John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. His book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. John's e-mail is jwaggoner@usatoday.com. Twitter: www.twitter.com/johnwaggoner.
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