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Author: TMFSynchronicity Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35357  
Subject: Re: A justification(?) for bond funds Date: 5/11/2000 9:59 PM
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dhatch wrote:"CAN'T AFFORD TO WATCH IT DROP ...",
You left out the "20%".

therefore you had better reconsider "BONDS AND OTHER FIXED INCOME INVESTMENTS" as "THE CHOICE HERE", because the actual realizable cash proceeds may really go down dramatically if you should cash out prematurely.

Yup, I know that. Bond values drop as interest rates rise. You could calculate the amount they should drop on a fairly simple spreadsheet (If a bond pays 5% over the next 5 years, and the prevailing rate is 7%, how much of a discount should that bond be selling at in order to give you the equivalent of a 7% annual return?) There are calculators that can do that equation, as well.

There is a risk of loss in any bond fund, but depending on the type of fund chosen, that risk can be pretty darn small (especially since I won't be investing "big chunk of money all at once, but rather smallish amounts over time). For example, VWESX, Vanguard's long-term corporate bond fund, had it's worst year since 1980 last year, losing...6.23% overall. The fund also lost 5.30% in 1994.

With a bond fund, the capital return will bob up and down over time as interest rates change. One is essentially buying the yield over the long term, as those changes in capital will wash out over time. Using VWESX as an example again, the arithmetic average capital return since 1980 is 0.93%, and the CAGR is 0.62%. (Yes, it's slightly positive over the years). That's background noise.

Investing in VWESX is a way for me to invest at a long term rate rather thana short term rate (although with today's inverted yield curve, that might not be that great) and also allows me to invest small amounts of money immediately and also reinvest all dividend amounts. I could not do this with US treasuries, which require a 1,000 minimum. A fund also offers me some flexibility. And Vanguard funds keep low expense ratios (0.30% or less. Since one is essentially buying the yield over the long haul, there is no way I'd pay over 0.50% in expenses for a bond fund. In fact, 0.33% is about my limit.)

The trade-off for this is some risk of loss, albeit small. That's a personal decision that I'm willing to make. One big reason why I'm willing to do this is that bond funds decline when interest rates go up. Well, if rates climb dramatically, I'll probably put off buying that house, as well.

One last comment
actual realizable cash proceeds may really go down dramatically if you should cash out prematurely.

Depends on how one defines "dramatic". My top choice for a bond fund is VBMFX, Vanguard's Total Bond Fund Market Index. The largest drop it's had in one year was 2.66% in 1994, and it appears to have dropped less than 5% from peak to valley at any time since its inception in 1986. I don't consider that "dramatic". And again, the sort of interest rate climb that would lead to a bigger drop would also keep me from buying a house.

Now, if I was investing a sizable sum all at once in order to generate a future income stream, I would ladder individual bonds instead of using a fund. I suspect many people here are in that situation.

That's why I'm leaning towards a bond fund, specifically VBMFX.

-synchronicity
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