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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 35367  
Subject: Re: Question about Bond Funds Date: 4/22/2006 1:06 PM
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"These are the choices available and of course our tendency is to look at past performance and pick the bond fund with the best performance. Probably not the best idea, so I'd like some help understanding these funds in order learn and to make an educated decision about the funds available."

Chasing past performance is a very nice way to lose a lot of money.

I presume your wife doesn't have the option of buying individual bonds, instead of bond fund or money market as the only fixed income options.

If you read this board, you'll see that most of us don't think much of bond funds, and not because we're like stock pickers, who don't lke funds because they think they are smarter, but because there are some inherent problems with bond funds.

In a rising interest rate environment (and remember, 1-2 years ago, rates were lower than they had been in 40 years, and they still haven't reached average), bond fund NAVs will drop, so your total return (dividends minus capital loss) will be less than the dividends alone. This won't beat investing in individual bonds or CDs: whether it beats a money market is hard to predict.

We've also been uncovering other issues about returns on bond funds that could make them even worse than they should be.

We don't know for sure where rates are headed (my mother-in-law informed me a couple of days ago that they were going up and to wait, so I'm almost certain the are headed down). Bill Gross, PIMCO's guru, who is considered the smartest guy about bonds also says rates are headed up, but about 6 months or a year ago, he said they were headed back down and they've been going up ever since. Really objective evidence, like National Debt, should suggest higher rates, but there are lots of other factors, like Asian lending and what the Fed does if the economy cools with high gas prices and falling real estate values.

Anyway, if you do want a bond fund instead of accepting money market yields, which aren't that much lower (at least the ones at Vanguard and TIAA-Cref), it is safer to stick with the shorter duration funds for now. The index fund should have a duration of around 4.5%, so a 1% point gain in relevant interest rates should only translate into a 4.5% loss to NAV.

PIMCO Total Return may attempt to outsmart the market (which an index fund won't): you'll pay a higher expense ratio for that and it may or may not succeed, but it is probably in the same risk category as the index fund.

TIPS (inflation protected) funds hold longer bonds, but should be only slightly riskier than the other two funds, because of how TIPS work.

The High Yield fund is a different can of worms: junk bonds track stocks more than interest rates, because the risks are of default during down economic times.

I don't know about the PC fund. I don't think social choice would make much of a difference in yield or risk.
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