Investing in Bonds – Keep it Simple
January 19, 2011, By Tyler Newton 0 comments
Investing in bonds doesn’t have the same macho appeal as investing in stocks. Bonds aren’t always about betting on price appreciation; they are usually purchased for the simple purpose of generating interest income. It is possible to make money with price appreciation in the bond market, however, it means taking on a little bit of risk.
Bond Basics
Rates up, prices down. The first thing to understand about bonds is that when interest rates go up, the price of existing bonds go down (and vice versa). For example, if I own a bond that pays four percent interest, and the interest rate on new bonds of equivalent risk is five percent, the price of the bonds I own will fall so that someone who buys my bond would also receive five percent. The math is complicated, so I’m not going to dwell on it, but that’s the general concept.
Duration risk. The prices of longer term bonds are more sensitive to changes in interest rates than shorter term bonds.
Credit risk. While the U.S. treasury bond is considered riskless, other bonds have some risk that the issuer (whether a company, a country or a municipality) will not repay all principal and interest. Bonds that have relatively little risk of not repaying are called investment grade (rated BBB or better by Standard and Poor’s). Bonds that are rated lower than investment grade are known as high yield bonds.
Investing in Bond Funds
Core bond holdings. Okay, so how does the average guy invest in bonds? The easiest thing to do would be to buy the Vanguard Total Bond Market Index fund (ticker: VBMFX) or the PIMCO Total Return Fund (ticker: PTTAX) and be done with it. If you have only a modest amount to invest, either of these funds is a good option as your only bond fund.
As with investing in stocks, it could also be a good idea to have some international bond exposure. The Templeton Global Bond fund (ticker: TPINX) and the International Treasury Bond exchange traded fund (“ETF”) (NYSE: BWX) are good choices. A safe split between domestic and international is probably something like 75 percent domestic and 25 percent international. When the dollar is strong, add more international to benefit from its eventual decline. When the dollar is very weak, add more domestic.
In taxable accounts (for those in higher tax brackets), the Vanguard Intermediate Term Tax-Exempt (ticker: VWITX) fund is a good option for mostly tax-free income to replace part of your core domestic basket.
Market timing. My personal rule of thumb is that long term bonds are attractive when the 10-year U.S. treasury bond is above 4 percent. The best time to invest in long term bonds is just before a recession, which interest rates typically fall, at which time you can add the Vanguard Long Term Treasury fund (ticker: VUSTX) in tax free accounts or the Vanguard Long Term Tax Exempt fund (ticker: VWLTX).
The best time to invest in bonds with credit risk is during recessions or shortly thereafter, when long term rates are low and credit risk is cheap. In those times, sell the long term funds and buy the Vanguard Intermediate Term Investment Grade fund (ticker: VFICX) and a little bit of the Vanguard High Yield Corporate fund (ticker: VWEHX). If you want to add credit risk to your international basket, you can also buy a little bit of the iShares Emerging Market Bond ETF (NYSE: EMB).
Of course, if you’re not comfortable market timing in this way, don’t. Bonds don’t need to benefit from price appreciation to provide returns. Either way, the portfolios above can provide nice diversification by holding only one to five funds at any given time, with low expenses and very little adjustment required.
