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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35345  
Subject: Re: Asset Allocation Date: 8/15/2005 10:29 AM
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"Also, a co-worker recommends closed end income funds. Any second opinions?"

See this recent thread on closed end funds. Banjoman's final comment that there ain't no such thing as a free lunch pretty much sums it up: closed-end funds, contrary to some popular belief, are not protected from "interest rate risk" (falling value of bonds currently held by a fund if interest rates go up) and if they have higher yields than other funds with similar mixes of maturities and qualities of bonds, it is because they are leveraged, which makes them all the riskier.

http://boards.fool.com/Message.asp?mid=22820707&sort=whole#22860825

"I am not so much concerned about the percentage of my portfolio in bonds and fixed income investments as I am about which ones to choose from for obviously the best combination of income weighed against risk."

First, if you really are in a position to retire in your 40s, unless you are someone with wildly optimistic assumptions about returns on your investments, we have to assume you have a lot of money. In that case, you are probably in a high enough tax-situation to be looking at municipal (tax exempt) bonds. In general, investment grade muni bonds are somewhat less risky than corporate bonds with similar ratings and, especially if you can buy them also exempt from your state income taxes (if you live in a state with income taxes), you will probably get a better after tax return if your federal bracket is above 30% (after retirement).

Currently, for those of us looking for fixed income investments that will basically provide us with dividends/interest and return our principal, the fixed income market is boring and unattractive. There are, of course, junk bonds, but those are more like investing in stocks (high risk). Sometimes there is a low investment grade bond that looks promising (some, here, were suggesting GM bonds, just before they got downgraded to junk), but it is rare that you can find something that is trading out of line with the risk (GM bonds were trading at a strong discount for a reason—they were junk in everything but name).

Beyond that, you should start by asking whether there is anything that can beat, in total return, a simple ladder of 5-year CDs. For the last few years, and at present, my answer has consistently been: not likely. If interest rates go up, this could change, so it is worth knowing the alternatives, and you can always roll over a CD into bonds or bond funds if those look more attractive in the future.

Alternatives to CDs are:

1) Treasury bonds and TIPS (not funds): like CDs, you can build a ladder, with bonds maturing at intervals, providing cash flow as well as ongoing dividends. Usually, longer maturities pay higher dividends, though at the moment the "yield curve" is very narrow (not much difference in yield between 3 year Treasuries and legacy 30 year Treasuries). TIPS are Treasury bonds with a fixed component plus inflation (CPI) adjustment: last I looked, the differential between TIPS and Treasuries presumed annual inflation less than 2.5% over next 10-20 years. With that, I would probably choose TIPS over Treasuries, though you can always mix and match. However, with the yields on 10-year Treasuries at around 4.25%, when I can get a 5-year CD at 4.75%, I'm sticking with CDs (for Treasuries to win, interest rates on 5-year CDs would have to be down to 3.75% when I roll one over 5 years from now).

2) Corporates: if you buy investment grade corporate bonds, you are looking to get enough better yield to be worth the somewhat higher risk compared to Treasuries. At this point investment grade corporates are all trading at high premiums, so to get a yield better than 5-year CDs, you have to buy a bond that isn't going to mature for at least 25 years. With interest rates still near historic lows, I wouldn't fancy locking a low yield for 25 years, plus some day you may need to use the principal.

3) Munis: If you are in the right tax situation, you may find muni bonds that are competitive with CDs. The problem is buying muni bonds, especially since there are often high brokerage fees that will eat into your yield, but if you are in the right tax situation, you should certainly explore this option further (start by looking at what is offered through the bond desk at your brokerage).

4) Funds: I'm lumping funds together, though there are a variety. Funds are an excellent choice when there is a likelihood interest rates will hold steady or even go down. They provide liquidity (you can just sell shares), regular dividends, and they can generally get you a better yield than you can by a mix and match bond buying strategy on your own (diversified corporates, longer maturities). The problem is, if interest rates go up, the fund NAV goes down (your shares are worth less), so your total return on the fund will be less than the fund's current yield (even though the fund's yield will go up). Right now, you aren't going to find a conventional fund with a high enough yield that it will beat a 5-year CD over the next 5 years, if interest rates go up at all. Historically, bond funds have provided a hedge against a falling stock market, because people fleeing stocks have bought bonds, driving up NAVs. However, if you look at what has been keeping bond yields low (notably, influx of foreign capital with the intent of keeping the dollar strong, despite the trade and budget deficit), this historic hedge looks pretty iffy.

I've left US Savings Bonds (EE-, I-) off the list, because the total amount you can buy each year is pretty small. However, even though they can't compete with CDs in the short run, with tax advantages (no state and local taxes, tax deferral on interest until maturity, which may mean a lower tax bracket after retirement), they may be worth maxing out with the idea of not using this money for 30 years.
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