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Here is my dilemma: I have never invested in bonds or bond funds, so I'm a novice to say the least. I am 29 and currently have 100% of my retirement (401K & Roth IRA) allocated across several stock index funds at vanguard. I would like to diversify ~20% of my retirement portfolio into bonds or bond funds, but I have no idea how to go about this. It seems like the consensus on this board is that there is currently a lot of interest rate risk for bond funds, so I'm not sure what to do. Any recommendations? I have an ~30-35 year investing timeline, and I plan to dollar cost average into both stock and bond funds during that time.

I also have a taxable account that's mostly in ING. Are there any better short term, low risk investments for money above and beyond my emergency fund. I-bonds, lattered cds, etc.?

Thanks in advance for any help!!!


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If you are concerned about interest rate risk, you should put your money either in money markets or in instruments that have fixed maturity dates. That would be CDs and/or bonds themselves (but not bond funds). It depends on how much you have to invest. If over say $25K, owning the bonds themselves becomes attractive--though you can manage with at little as $5K if you are determined.

The magnitude of the interest rate risk is debatable. Its likely the Feds will adjust rates upward a step or two once the economy seems to be in solid recovery, but thereafter rates may be stable for quite a while.

The best way to deal with the step is to invest in CDs that mature after the rates have plateaued. You can easily calculate how much various increases will cost you and how much yield you give up now to protect against that. From those back of the envelope calculations you can arrive at a strategy that keeps you from over reacting either direction.

No one really knows when, or if these changes will occur, but if you guess correctly and plan accordingly you can maximize your return. Otherwise, your return will be a bit smaller.

Best of luck to you.
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The emergency fund part is relatively easy. As I've mentioned before, I think it is important to divide what many people call an "emergency fund" into two conceptually different funds: one for everyday things that go bump in the dark (like a new engine for the car) and one as a rainy day fund, for major illness and unemployment.

If you are relatively securely employed (is anyone?), you can probably just keep enough money easily on hand, like in a bank money market, to get you through the everyday emergencies—I've got about $3000, with $2000 as the minimun needed to get money market interest, anyway. For the contingency fund, it's a toss-up—a few months ago, 5-year CDs were clearly a better choice than US Savings bonds, but CD rates have come down. if you've got a big lump sum, I'd probably go for a ladder of 1,2,3,4,5 year CDs. If you are trying gradually to build up your contingency fund, then it's really like dollar cost averaging by dripping money into an index fund, and you might as well go for the 5-year CDs each time you buy. Or, look at EE or I bonds. A lot depends on your state tax situation (if you have high state income taxes, US Savings bonds are a better bet than if you have low state income taxes). In a 30% federal bracket with 4% state income tax, it takes about 20 years for a US Savings bond to catch up with 5-year CDs if its average yield is about .5% lower. But, at your age, if you really don't touch the money,Savings Bonds are probably a better choice. We've debated between I-bonds and EE bonds at current rates—historically, I-bonds at current fixed rate should underperform EE bonds over time, but it seems quite possible we will go through a period over the next few years where treasury bond yields (upon which EE bonds are based) will stay low, but inflation will not. Then again, who knows.

As to the retirement funds: you've got 40-50 years. Given the low interest rates, I'd probably go ahead and continue dripping into the stock index. With 20 years, I've stopped. With Roths, for which I figure 40 years (or death first), I'm going with the balanced index fund. But we've got enough stock index money already, if stocks do okay, and far too much if they don't.
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Hey Lokicious,

Thanks for your reply.

For the contingency fund I was looking at ING (for a CD ladder):

Term APY
1 Year 2.80%
2 Year 3.10%
3 Year 3.50%
4 Year 3.90%
5 Year 4.35%

Looks like I bonds are currently yielding 4.08% (only 1.6% fixed)

Are you saying that a laddered CD portfolio is generally better unless you're leaving the money invested for a long period of time (> 20 years) and you have a high state income tax?

In addition, I was hoping you or someone else might have some further advice regarding the bond portion of my retirement portfolio. Again, I have a Roth at Vanguard and a 401K - currently 100% equities. I want to change this to 80% equities - 20% bonds. It sounds like bond funds are not the way to go. Any advice on researching and finding individual bonds to buy. Can I do this through my Vanguard account and if so, do you pay steep commissions? Is there a cheap way to buy individual bonds. Also, I just want to make sure that dollar cost averaging into a bond index fund over the next 30-35 years is not the way to go.

Thanks again for your help!

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Ing is barely below what my credit union is yielding now, and it's been well above anything else for most of this year.

"Are you saying that a laddered CD portfolio is generally better unless you're leaving the money invested for a long period of time (> 20 years) and you have a high state income tax?"

I'm talking about a ladder of 5-year CDs, but that is presumably what you would be doing as you rollover your first installment. It's hard to run calculations with 5-year CDs and I-bonds, which are more variable, and there are some times (as with my credit union, until now) where you may find opportunities where one option looks clearly better. So, try using a ladder of 5-year treasuries as a basis for comparison with EE bonds. EE bonds are 90% of the average for the previous 6 months of 5-year treasuries. So, calculate how long, given your tax bracket (or likely average tax bracket) it will be before the compounding advantage of deferring federal taxes takes to compensate for getting 9% yield. In theory, 5-year CDs should pay enough extra yield over 5-year treasuries to cover paying state taxes—in reality, this doesn't hold perfectly true, which is why sometimes you can find an advantage.

As to your stock question, reread my previous post, which is the best I can do. At your age, given bond interest rates now, I would probably go ahead and drip 100% into stocks in the retirement funds, then add a bond component when interest rates go up, and thereafter try to keep a specified balance, maybe usng the 100-your age formula.
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