A Good Buy Today or Yesterday?
Martha Carter has a CD coming due in three weeks. A mutual fund, annuity and stock fund investor, this savvy Miami investor is wondering where she can find higher yielding returns and she's stumped---just like millions of other retirees.
Living off the income on CDs used to be a way of life for retirees. Those in their 80s and 90s today remember the 1980s when double-digit certificates of deposits were as common as bingo on Thursday nights. In the past 20 years, however, all that has changed---except for bingo on Thursday's---as interest rates are at lows not seen in decades.
Add to that the fact that the 30-year Treasury bond is no longer being issued, those looking for a safe, long-term fixed income investments will have to look elsewhere. That means for many, their first choice may be bond funds.
While bond funds can be great, investors need to be mindful of how they work---particularly in an environment in which interest rates are falling. So, here are three things to keep in mind before investing into a bond fund today:
1. Total Return. The performance quotes investors see regarding a particular bond fund reflect its total return. And, as in stock funds, a bond fund's total return reflects both changes in the price of the underlying securities held in its portfolio and any dividend or interest income, over a given period of time that's already behind us.
2. Bonds prices. Because the price of a bond is directly tied to interest rates, every time there's a change in interest rates---either upwards or downwards--- there will be a change in the price of the bond.
While that's easy enough to follow, where things get complicated is in the direction of those price changes. When interest rates fall, the prices on bonds rise; when interest rates rise, the price of a bond gets cheaper.
3. The challenges. The first challenge investors, like Carter, face today when they're looking at those juicy single and double-digit total returns on bond funds is figuring out where those returns came from. Since the Fed has reduced interest rates 10 times so far this year, and because falling interest rates cause bond prices to go up, it's fair to say that a lot of the appreciation in the value of many bond fund portfolios has happened because interest rates have fallen. That's why those already owning bond funds have had a lot more to crow about this year than those holding shares of say growth stock funds.
The second challenge investors today face is to think about tomorrow and where interest rates might be in six-months or a year or two.
If you're a believer that interest rates still have room to fall, then bond funds will look more attractive to you than someone who thinks that in the near future we'll be seeing rising interest rates.
For those who think interest rates are about as low as they can go, and that by next year will probably be heading upwards, bond funds won't be such an attractive pick as higher yields reduce bond prices and thus can reduce a fund's total return.
So what are investors like Carter to do? The best anyone can do is to consider all of their options ; understand all they can about the investments they make; and to remember that the market is what the market is.
Dian Vujovich is a nationally syndicated mutual fund columnist, author of a number of books including Straight Talk About Mutual Funds (McGraw-Hill), and publisher of this web site.
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