What are the best ways to invest with bond funds in 2012? If you thought stocks face an uphill battle in 2012, bonds have a similar challenge. The same questions that dominated the beginning of 2011 still loom in 2012: Will the economy finally stabilize or will it tip back toward recession? What will inflation do? When will interest rates go up?
2012 Expectations: Bond Prices, Inflation & Rates
What fixed income funds (bonds) do in 2012 depends primarily on the same guiding force as stocks -- world economies. Most of the countries of the world, including the US, are facing weak economic conditions or significant chances of recession in 2012 and they all overlap and influence each other. The real determining factor for both bond prices and stock prices is expectations.
Even if economic conditions are poor in 2012, investors' expectations will be met and prices for investment securities, as a whole, will not fluctuate much on an annualized basis. If economic conditions become worse than investors now expect, bond prices could go up as stock prices go down. If economic conditions become better than investors now expect, stock prices would likely go higher but so would inflation and interest rates, which would push bond prices down.
Best Bond Fund Types in 2012
Now the question of where to invest in 2012 for bond funds begins to take a logical shape. Bond prices move in opposite direction of interest rates and interest rates are sensitive to the economy and inflation. The chances of interest rates going lower are almost zero because rates, specifically federal funds rates, are already near zero. And because falling interest rates are good for bond prices and bond funds (and vice verse), there is no real impetus to push bond prices higher unless economic conditions decline so much that the rush to buy bonds for safety pushes up prices.
In summary, the investor who wants to use bond mutual funds in the most practical way -- as a diversification tool -- and who wants to get the most out of bonds in the current and near-term economic environment will consider a few bond fund types for 2012:
- Short-term Bonds: If the economy gains strength in 2012, which up to 50% of economists believe will occur in the second half of 2012, interest rates could begin rising, which will push bond prices down. Because of the bond price sensitivity to interest rates, short-term bonds will not be as adversely affected as, say, long-term bond funds.
- Intermediate-term Bonds: This may be the best balanced approach. Long-term bond funds are not worth the risk if and when interest rates begin rising and short-term bond funds will not provide much of a return to the investor. Therefore intermediate-term bond funds provide a happy medium to strike a balance between minimizing interest rate risk and maximizing potential for gain.
- High Credit Quality: We've covered duration (short-term, intermediate-term and long-term) but we need to touch on credit quality. Credit agencies, such as Moody's and Standard & Poor's give corporations and government entities a credit rating, which generally ranges for AAA for high credit quality to C for low credit quality. In an uncertain environment, high credit quality is a better bet than low credit quality because bond holders don't want to risk default in a weak economy.
Using Bond Index Funds and ETFs in 2012
In addition, you may want to consider bond index funds, such as Vanguard Total Bond Market Index (VBMFX) in an uncertain environment because even the best fund managers can make mistakes. Also there are some good bond Exchange Traded Funds (ETF), such as iShares Barclays Aggregate Bond (AGG), to consider. Some investors have also recently considered or used Treasury Inflation Protected Securites but these bond types, called TIPS, have pros and cons to them.
If you do your own research for bond funds, just look for intermediate-term, high credit quality funds on Morningstar and, as always, use funds with low Expense Ratios. Also, be sure to look at my other Where to Invest articles to get ideas on how and where to invest in 2012.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.