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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 35400  
Subject: Re: Bond Funds or CD's Date: 8/14/2005 10:28 AM
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Which is better, a CD ladder or a bond fund, depends on whether interest rates are likely to go up or down. Of course, we have been guessing wrong about interest rates for the last few years.

If you build a ladder of 5-year CDs, you will typically get the yield of an intermediate bond fund (which holds bonds with average maturities in the 5-year range). During the low yields of the last few years, the yields on Vanguard's Total Bond Index fund have usually been about .25%-.5% below 5-year CDs, while their Intermediate Bond Index fund has been near the yields on 5-year CDs.

Laddering CDs gets you almost as much liquidity as a bond fund (let's say a CD maturing every 3-months). Laddering will get you average yields. You won't get a capital gain if interest rates go down. You won't get a loss if rates go up.

Contrary to what commonly gets implied (including by Vanguard), the increased yield on a bond fund when interest rates go up will not compensate for the decrease in NAV during the time frame of the fund's duration (basic arithmetic)—so if the fund's duration is around the time frame of a 5-year CD, you can calculate what will have to happen to relevant interest rates in order for that fund to beat the CD. (If the starting yield is below that of the CD, interest rates would have to go down for the fund to win.) If you are looking at funds with durations of less than 5, you probaly won't have to worry about the NAV taking a huge loss (unless interest rates go way, way, up), but your total return will still be less than the initial yield. If you don't reinvest dividends, which is typical after retirement, the downside is even worse.

Bottom line: until you are convinced (guesswork, of course) interest rates have peaked, laddering CDs is the better choice, as long as you can get CDs with similar or higher yields to funds. I am going to start looking at 10-year TIPS as a supplement if they are being offerred at above 2% fixed yield come next January's auction. Probably won't bite for less than 2.25%.
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