Bob Brinker Muni, GO and Bond Fund Advice

Many callers have asked Bob Brinker about the potential to lose money in bond funds when interest rates "normalize" from historically low rates. For example, on April 5, 2010 the 10-year US Treasury Bond had a yield of 3.99%. (move the cursor over the chart here for TNX to April 5 to see the rate quoted as a "price").   Much of this year's gains in bonds are due to the yield falling to 2.70% as investors have fled stocks while pouring money into bond funds.  See:

• Equity, Bond & Money Market Fund Flows

• US Treasury Rates at a Glance.

Brinker says if you hold a bond fund the simple thing to do is use a mental stop loss as I explain in the article Bob Brinker's GNMA Advice.

Brinker also points out another way to avoid losing money is to buy bonds directly and hold them to maturity. If you buy US Treasuries or GNMAs directly, then you are guaranteed to get your interest payments plus principle back since the government can borrow money from the Federal Reserve which will turn on the printing press if there are not enough interested in the low rates.

If you own municipal bond funds to lower your taxes, then Brinker says you can buy tax exempt Municipal Bonds directly from your broker. Buy NEW ISSUES to get the lowest fees. If you were worried about the quality of municipal bonds, then Brinker says you could purchase high quality state general obligations (GO Bonds) which have had no failures in over a century.  (As a Californian, I find little relief in that fact given the circus we have in Sacramento giving huge raises and pension benefits to unions that support the people in government that keep spending while the state circles the drain of insolvency.  End of digression.)

My Warning: You need to be careful with Muni bonds because some cities, struggling with the recession, have missed payments and could default. Harrisburg, the capital of of Pennsylvania, is the latest to miss a payment and potentially default.

Pennsylvania capital, Harrisburg, skips payment, may move closer to bankruptcy
Harrisburg Mayor Linda D. Thompson has adamantly opposed declaring bankruptcy, while the move has been been advocated by the city controller and a growing bloc on the City Council. 
and
The city's bond insurance company is expected to cover its upcoming $3.3 million bond payment. But some analysts say relying on that backstop could add to the mounting pressure on firms that provide insurance for the $2.8 trillion municipal bond market.

The good news for investors is the insurance company will make the payments but if enough cities and states like California (even with with insurance) miss payments, it could get nasty.

Seeking Yield for Income Is Risky 

Currently, if you need yield, it means you are taking significant interest rate risk.  Buying bonds directly is fine if your goal is to not lose money but if there is high inflation, then you will lose purchasing power to inflation whereas someone in money funds, TIPS, Ibonds or savings accounts will do much better since we will get higher returns as rates normalize (go up.)  Everyone should be aware that the Federal Reserve is again buying US Treasuries to help keep rates low and nudge investors to take more risk to help the economy grow again.  Rates could surge again when (not if) the Fed stops buying US Treasuries.

Vanguard's GNMA fund, VFIIX, currently has an average duration of 1.7%.  That means if interest rates were to jump 1% overnight, you could expect VFIIX to lose 1.7% in net asset value, NAV.  If they jump 3%, expect NAV to fall by 5.1%, 3 times 1.7%.

• VFIIX Chart and Quotes

I am lucky. I have enough cash flow from my Two Investment Letters, people clicking ads on my blogs and websites plus commissions for products I recommend that I don't need yield to live on.  Thus, I take very little interest rate risk.  I've sold all my bonds and bond funds not indexed to inflation with my own money and in  "Kirk Lindstrom's Investment Letter." 

My personal iBond portfolio currently yields 5.43% (Majority are from Oct. 2001) but of course, I only get the interest at maturity, a great way to defer taxes.  The TIPS fund I got for my Vanguard ROTH by selling the GNMA fund is up 18.4% in under 2 years.  I also hold individual TIPS and a significant holding in the TIPS fund at Fidelity, FINPX, that is up 25.8%.  I suspect those TIPS funds will give back some when rates normalize, but rates probably won't normalize without a significant inflation component so I expect they will do better than bond funds not indexed to inflation.

Many of the stocks in "Kirk's Newsletter Explore Portfolio" are paying a great dividend while selling at very low price to earnings multiples.  My portfolios are up significantly over the past 10 years while the index funds are down.   I expect equities to significantly out perform bonds and probably CDs over the next decade and my "core plus explore" portfolio approach should do even better.

Subscribe NOW   

and get the October 2010 Issue for FREE!!

For details on both my newsletters, read

Kirk's Two Investment Letters