Investors Buy Into Bond Funds
In the July 12 issue of the Forecasts, we raised our recommended cash position to a range of 25% to 35%. Of course, in a low-rate environment, bond funds can be a better choice than cash holdings.
The average money-market fund yields just 0.8%, versus 4.0% for the average taxable intermediate-term corporate bond fund. In June, more than $19 billion flowed into bond funds, compared to outflows of roughly $7 billion for stock funds.
But with many investors stampeding into bonds, particularly those issued by the U.S. government, the bond market may be overheated. The 10-year Treasury note yields just 3.1%, down from 3.8% at the start of 2010 and well below the 10-year average yield of 4.3%. Meanwhile, through July 13 the average long-term government bond fund had surged 13.5%, well above the 10-year annualized return of 8.1%. The table below lists average yields and returns for eight popular bond-fund categories.
Bonds enjoy a reputation as conservative investments, enhancing their appeal when stocks are volatile. But bond funds can lose money. According to fund-rating outfit Morningstar, bond funds posted negative annual returns three times from 1985 to 2009. Looking ahead, the potential for Federal Reserve interest-rate hikes is worrisome for bond investors. Bond prices generally retreat when interest rates rise.
Still, bonds offer fairly stable performance relative to stocks and remain an important means of preserving wealth. To that end, three attractive bond funds are profiled below.
Vanguard GNMA ($11; VFIIX) invests in government mortgage-backed bonds and yields 2.9%. Mortgage-backed securities pay higher yields than Treasurys, in part because of the risk that investors will prepay the underlying mortgages. Still, the fund has not declined in the last 15 years.
Vanguard Short-Term Investment-Grade ($11; VFSTX) is a top pick among conservative bond funds. We have recommended this fund for our cash position since 2002. Yielding 2.4%, the fund invests mostly in investment-grade corporate bonds. The fund, which holds bonds maturing in an average of three years, has had only one losing year since 1995 — a 4.7% decline in 2008.
Vanguard Total Bond Market Index ($11; VBMFX) mimics the Barclays Capital U.S. Aggregate Bond Index of government, corporate, and mortgage-backed securities. The fund, yielding 2.9%, has posted 10 consecutive years of gains.