Dont bail out of bond funds
The reach of the financial meltdown is wide, the pain acute. But for disheartened bond investors, many facing a year that could end in the red, now is not the time to run for the exits.
In such a tumultuous environment, you need to size up your bond funds.
• Start by reviewing the credit quality of a fund’s holdings. As the economy weakened in recent months, many investors fled from securities with even a whiff of risk. Bonds with lower credit quality (Standard & Poor’s credit ratings of BB or below) have suffered the most, dragged down by fears of default. While investment-grade bond funds (ratings of AAA through BBB) have fared better, they, too, are posting losses. Refer to a fund’s annual report for its holdings and credit quality.
One bright spot remains: U.S. government bonds, considered a safe haven because of their zero default risk. The average intermediate-term government fund has returned 1.2% so far this year, compared to a decline of 7.2% for diversified intermediate-term funds, which typically hold both government and corporate bonds.
• Also consider the maturity of your fund’s holdings. The average short-term government fund, which typically holds bonds maturing in less than four years, has risen 2.6% this year. In contrast, long-term funds (maturities average 20 years) have climbed 1%. The contrast is more pronounced for funds exposed to corporate bonds. Long-term corporate bond funds have plunged an average of 12% for the year, while short-term bond funds are down 3.9%. A good measure of interest-rate sensitivity is duration, which investors can find at www.morningstar.com, the Web site of Morningstar, a provider of mutual-fund data. The shorter the duration, the less sensitive a bond fund is to changes in interest rates.
• Finally, investors in a high tax bracket should take a close look at tax-exempt municipal bonds. Their tax-exempt status usually pushes down the yields of muni bonds relative to taxable bonds — but not lately. Intermediate-term municipal-bond funds now yield about 4.3%, versus 3.7% for 10-year Treasurys. A tax-free yield of 4.3% is the equivalent of a taxable yield of 6.4%, assuming a 33% federal tax bracket. The chief risk of municipal-bond funds lies in the uncertain financial health of state and local governments coping with budget shortfalls and investments in risky securities.
The wholesale selling of bond funds in favor of cash is a bad idea for most investors. However, today represents a good time to review individual holdings. If your bond fund trails its peers, consider upgrading to one of the following three choices:
Vanguard Short-Term Investment-Grade ($9.72; VFSTX) is down but not out. The financial crisis has put the fund, down 4.9% so far in 2008, in danger of its first losing year since 1994. The fund’s yield has risen to 6.1%. The expense ratio is 0.21%, well below the category average of 0.95%. The fund holds primarily high-quality corporate bonds with maturities of less than three years. About 39% of its 810 bonds maintain a credit rating of AAA, the highest possible. Major sectors include finance (30%) and industrial (25%).
Vanguard GNMA ($10; VFIIX) invests almost exclusively in Ginnie Maes. These mortgage securities, fully backed by the federal government, rose in value when the government took over Fannie Mae ($1; NYSE: FNM) and Freddie Mac ($1; NYSE: FRE). The fund has been a rare investing success story in 2008, rising 3.4%. With a yield of 4.8% and a modest expense ratio of 0.21%, the fund has averaged a 5.4% annual return over the past three years.
Vanguard Short-Term Treasury ($11; VFISX) is a conservative, very short-term fund that has become one of this year’s few winners. Up 5% this year, the fund invests only in government and agency debt, and 37% of its assets are set to mature in less than a year. The expense ratio is a lean 0.22%, while the yield is 1.8%.