Switch from bond funds to CDs before interest rates rise
It's time for savers to say goodbye to their bond funds and return to CDs.
No one blamed savers for bailing out when CD rates began falling in 2008 and just kept on going down, down, down.
They could make a lot more money from mutual funds that invested in Treasury bills, corporate debt or even government-guaranteed mortgages.
Double-digit returns were pretty common.
More than $376 billion poured into bond funds in 2009, according to the Investment Company Institute, up substantially from the $28 billion added the year before.
That amount tailed off to $216 billion in 2010, but the trend of savers moving from certificates of deposit to bond funds continued.
But bond funds are losing their advantage over certificates and it's time for savvy savers to change course.
When interest rates fall, the price of government and corporate bonds go up.
When interest rates rise, those prices go down, taking the share-price of most bond funds with them.
Over the past several years the Federal Reserve has done everything in its power to drive interest rates down to record lows in an effort to boost the economy.
That's what fueled the incredible run-up in share-price most bond funds --and bond fund owners -- enjoyed.
But the Fed's campaign to buy $19 billion a week in government bonds (driving the price of those bonds up and the yield of those bonds down) is scheduled to end in June.
There's a growing sense that interest rates have nowhere to go but up – and bond prices down. You bought low. Now's the time to sell high.
Instead of continuing to beat CD rates, the returns on bond funds could lag behind or even go negative.
It’s already started to happen even though interest rates have not yet begun to rise.
Just take a look at the less-than-stellar returns on two well-known bond funds that are widely held by individual investors.
Both the Fidelity Government Income Fund and the Vanguard Total Bond Market Index Fund saw their share-price fall for the six months covering November 19, 2010 to May 20, 2011.
Investors lost roughly 1% off the share-price.
If you had bought a certificate six months ago instead of either of those funds, you probably would have come out ahead.
What’s even more surprising is that bond funds have slumped without either of the two triggers that could really cause problems - Federal Reserve rate hikes or rampant inflation – cropping up.
If you are a saver caught in the bond market trap, you could soon be losing sleep over the growing uncertainty of your returns.
That’s where certificates come to the rescue.
A good financial strategy is to switch out of bond funds and back into a mix of short-term and long-term CDs.
You should follow a strategy called laddering that sets your certificates up to mature at regular intervals, usually every three to six months. (Our 3 steps to build the best ladder can help you do this.)
It allows you to take advantage of higher interest rates, instead of getting blindsided by them.
By spreading out your maturities, you actually boost your savings over the long run.
You can search our database for best, up-to-date rates from scores of banks.
Here are three more smart reasons you should make the switch:
Smart reason 1. Bond fund distributions are falling…
Bond fund investors make money two ways – rising share prices and the distributions they earn from the interest paid on the debt in the fund's portfolio.
Unfortunately, much of the high-paying government and corporate bonds once found in their portfolios has matured or been paid off and replaced with much lower-paying debt.
As a result, bond funds are paying out less than they were last year or the year before that.
Take for example, a 10-year Treasury bill that a bond fund might have purchased from the government on May 15, 2001.
Over the past decade the fund has earned 5.50% on that debt. A replacement Treasury bill bought the day after it matured on May 16 will pay just 3.15% over the next 10 years.
Smart reason 2. …But fees are not.
A nice feature is that there are no fees – period.
But bond funds charge monthly administrative fees that reduce your rate of return.
That's not much of a concern when share prices are going up and those fees eat up a relatively small percentage of your profit.
But when share prices and distributions are declining those fees can wipe out what little profit you might be making, or even add to your losses.
Smart reason 3. Certificates have always been safer investments.
When you buy certificates of deposit from government-insured banks you know your principal is secure.
But bond fund prices change every day based as the value of the debt in its portfolio goes up and down.
Simply put, the shares you pay $1,000 for today could be worth only $900 tomorrow.
Funds can try to offset some losses by purchasing derivatives, a type of insurance policy against rising interest rates.
But if there's anything we've learned in the financial chaos of the last couple of years, it’s that we shouldn’t be too quick to trust complex financial strategies to save the day.
The risk associated with bond funds is worth taking when they're paying a much greater return than safer investments, such as CDs.
But when that's not the case, they're not worth losing sleep over.