You’d Sooner Make a Bit More?
You’re saving up for a near-term financial goal like a house down payment or college tuition for a youngster. Or perhaps you simply want to establish a rainy-day account.
In such cases, you certainly would want to stick with bank savings certificates, short-term Treasury bills, money market mutual funds and other ultra-safe investments, right?
Not necessarily.
It might make more sense to move up just a notch on the risk scale and use short-term bond mutual funds for at least part of your savings.
Odds are the higher yields on these will more than offset their risk of principal loss, especially if you plan to retain your account for at least a year or so.
“Investors pay too much for the absolute certainty of knowing that their principal will be returned in full,” says Brent Harris, chairman of Pimco Funds in Newport Beach, which specializes in fixed-income investments. “How they pay for that is in accepting lower yields.”
Money market funds are much more popular than short-term bond portfolios, counting about 10 times as much in assets. But is their greater popularity really justified, given the higher yields, with some additional risk, available by owning short-term bond funds?
No, says Vanguard Group, which recently compared the results of money market investments against short-term bonds over various rolling periods from 1987 through 1996.
Vanguard found that short-term bonds--those maturing between one and five years--outperformed money markets in 83% of the rolling 12-month periods during that stretch, and in 98% of the 24-month periods.
And over any 36-month span during the decade, short-term bonds beat money markets every time.
Note, too, that the 1987-96 stretch included one of the worst years ever in the bond market: 1994, when market interest rates soared, devaluing even shorter-term bonds. But even in that year, short-term bond funds didn’t fare too badly, posting total returns--interest earnings plus or minus change in principal--that were only slightly negative for the year.
*
What’s more, investors who bought short-term bonds at the start of 1994 and held on into early 1995 would have broken even, as market interest rates fell again, says Brian Mattes, a Vanguard spokesman in Valley Forge, Pa. And “you would have pulled even compared to a money market investment within about 18 months,” he adds.
For investors who don’t expect to have to tap their cash reserves for perhaps 18 months to two years, Mattes suggests considering placing at least half the cash in a short-term bond fund and perhaps the rest in a money market fund.
As a rule, debt instruments with longer maturities yield more than their short-term counterparts. For example, Treasuries coming due in two years currently yield more than 1 percentage point above what three-month Treasuries pay.
The short-term bond arena is characterized by an especially favorable risk-reward mix, Harris argues, partly because money market fund managers can’t venture into IOUs maturing beyond 12 months or so.
“Once you pass beyond one year, you enter a bit of a no man’s land until you get into bonds with much longer maturities,” Harris says. “We find a lot of opportunities in this area.”
But before you stake most of your safe-haven cash in short-term bond funds, heed the following:
* Analyze portfolio composition. Short-term bond funds are more heterogenous than money market products, which are strictly regulated. Some short-term bond funds buy bonds maturing in four or five years and thus are riskier than others targeting IOUs coming due in just one or two years. Also, some short-term bond funds try to boost their yields by purchasing bonds issued by shaky companies or municipalities--a tactic not open to money market portfolios.
* Beware of costs. Short-term bond products typically carry higher ongoing management expenses than money market funds. Some also levy small front-end sales charges, something you never pay in the money market arena.
* Investigate check-writing restrictions. You might find it easier to write checks, especially those for smaller dollar amounts, against a money fund than against a short-term bond portfolio. But this drawback can be easily overcome by switching assets by telephone from a short-term fund into a money market portfolio at the same firm.
* Prepare for more record-keeping. Withdrawals from money market funds don’t trigger tax consequences, since these portfolios maintain a stable $1 share value at all times. Not so with short-term bond portfolios, whose share prices fluctuate, albeit usually only modestly, with market interest rate shifts.
Thus, each withdrawal you make from a short-term bond fund could produce an investment gain or loss that you would have to record for tax purposes.
But figuring tax calculations isn’t especially challenging. As for the capital gains and losses, “they tend to wash out over time,” Harris says. “And you’ll be left with the higher returns.”
*
Russ Wiles is a mutual funds columnist for The Times. He can be reached at russ.wiles@pni.com
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
California Municipal Bonds
T. Rowe Price & Associates tracks the yields of 20 California municipal bonds and the Bond Buyer Index of 40 national issues.
Bond Buyer 40-bond index, April: 5.98%
California index, April: 5.91%
Five Widely Held California Bonds:
Issue: Calif. general-obligation 10-yr
Coupon: (generic)
Maturity:
Yield, April 18: 5.30%
Yield, Friday: 5.30%
*
Issue: Calif. general-obligation 20-yr
Coupon: (generic)
Maturity:
Yield April 18: 5.80
Yield, Friday: 5.83
*
Issue Los Angeles MTA (insured)
Coupon: 5.50%
Maturity: 7/1/17
Yield April 18: 5.82
Yield, Friday: 5.86
*
Issue: Calif. public works lease rev.
Coupon: 6.0
Maturity: 10/1/14
Yield April 18: 5.90
Yield, Friday: 5.92
*
Issue: San Fran. airport (insured)
Coupon: 5.60
Maturity: 5/1/24
Yield, April 18: 5.92
Yield Friday: 5.95
Source: T. Rowe Price & Associates in Baltimore, which manages a $150-million California bond fund
Note: All yields are as of 2 p.m. Friday. Yields are based on institutional trading, retail prices and a survey of California brokers. Yields offered to individual investors will vary.
