The Implementation: The Bond

640px-Sean_Connery_1971Looking back at my own risk appetite, I realize that a large portion of my portfolio should be in the boring world of bond funds. And even if you have a greater risk appetite than I do, I would argue that some portion of your portfolio should be in the world of bonds. You never want to chase capital flows between bonds and stocks, so it’s better to have a set amount allocated at the start.

The question is which bond fund. If you are a John Bogle (founder of The Vanguard Group) follower, you would advocate a total bond market index fund, something like the Vanguard Total Bond Market Fund (VBMFX). This fund would give you a broad exposure with 65-70% in US government bonds and the remainder in corporate bonds. However, if you are invested in a taxable account, regardless of your tax bracket, Uncle Sam will take a chunk of the income generated from the dividends.  And if you are re-investing your dividends back into the fund, this would mean paying taxes on income you aren’t touching.

For a taxable account, I would want you to strongly consider the advantages of municipal bonds. Municipal bonds are issued by cities and counties for projects ranging from road construction to building stadiums. Some of the bonds issued are taxed but the majority are exempt from federal income tax (including AMT) and if you reside in the state where the bond was issued they may also be exempt from state income tax.

You could purchase individual bonds, but typically you would have to purchase a bond through a broker and that broker would typically take a commission on the face value of the bond. You also would have to have some knowledge about what you are purchasing in terms of credit quality of the issuing municipality. Not all municipalities are the same, currently the island territory of Puerto Rico is on the cusp of defaulting on billions of municipal bonds. The nice part of owning a single bond is that as long as you are able to hold the bond to maturity and municipality does not default, your capital will be returned. The downside to owning bonds is that they are traded in a bid / ask market and trading volumes can be low which means there can be spreads between the asking price and the bids. In other words, the exact value of the bond if you would need to sell it before maturity is not clear and can lose or gain value depending on interest rates.

So what’s the small investor to do? I would turn to municipal bond funds that provide broad diversification and professional management. Obviously, the management of a portfolio of bonds comes with a fee. However, with choosing the right fund the fee can be minimal. I again would turn to Vanguard as they by and large have the lowest fees in the market on any given product. They have multiple tax-exempt offerings. When looking through the offerings you should consider a couple things. First, a national bond offering is inherently more diversified than a state specific fund. The state specific fund would carry a greater tax advantage for residents of that state, however if there are no state specific funds for the state in which you live or if their is no state income tax in your state, the choice is clear.

Once you have decided whether to invest a national or state specific fund, the second question to figure out is duration of the bond fund. Shorter-term funds invest in bonds that have a duration of less than 2 years. With shorter terms there is less interest rate risk (if interest rates increase the bonds will trade at a discount to their face value meaning the bonds lose value) because the bonds mature in relatively short time periods and the capital is returned. Less capital risk is great, but there is a trade off in that the short-term funds have lower annual returns because interest rates for short-term loans are generally lower than long-term loans.

I have chosen to invest in longer duration funds. These funds offer  a higher rate of return and they have performed well since inception. We may be entering a rising interest rate environment, although that is debatable as the Fed has done nothing to actually unwind its balance sheet. That being said there is greater risk to the capital invested in these funds than shorter-term funds.

One thing to keep in mind when choosing your bond fund is why you are purchasing the fund. If it’s to bring stability to your portfolio, then you should consider avoiding the “high-yield” bond funds. These funds attempt to increase returns by investing in higher risk municipalities. Their annualized returns may better the typical or more credit worthy long-term bond fund. However, during downturns in the economic cycle, these funds act more like equities than bonds, and the part of your portfolio that should cushion the blow of falling equity prices will in fact exacerbate it.

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