One of my most-visited articles on mutual funds is Where to Invest 2012: Bonds. This is for good reason because investors are searching for alternative choices to bond funds. Why are investors considering shifting from bond funds to other security types?
As I highlighted in my previous post, Bernanke Testimony Hints at Bond Fund Decline, unless we see a doomsday scenario play out, it is likely that interest rates will begin rising some time within the next 6 to 18 months. This means the 30-year bull market for bond funds is likely coming to an end in the near future because, as interest rates rise, bond prices fall. Mutual fund investors are not able to avoid price risk because they do not hold the bonds directly and therefore cannot hold the underlying bond securities to maturity or choose to sell the bonds at any time in the open market.
The best way to minimize the price risk is to begin buying individual bond securities. I'll have much more to share on this topic in the coming days and weeks but let's take a quick glance at the basic types of bonds now:
- Treasuries (T-bills, T-notes, T-bonds and TIPS) may be relatively "safe" but the yields are so low that their best role in your portfolio will be for diversity but certainly not for decent income.
- Municipal Bonds can offer tax advantages if you plan to hold them in a taxable brokerage account (not a tax-deferred account, such as an IRA). However, similar to US Treasuries, yields are generally low now and some municipalities will fall under increasing financial strain as local and state governments feel the negative trickle down effect of the federal debt and budget problems.
- Corporate Bonds may provide the "sweet spot" of decent yields with relatively low risk, but this is a "buyer beware" purchase so be sure to do your homework on corporates (Stay tuned here for more info soon on how to do your own bond research).
- Junk Bonds (High Yield) should be used with caution. Many investors make the mistake of using high yields as the primary selection criteria for bonds but the high yields are reflective of greater default risk with the issuing entity.
Stay tuned for more information on adding individual bonds to the fixed-income portion of your investment portfolio.