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Tuesday, December 16, 2008

High Yield Fixed Income Investmets - Beware the Hype and Allure

When the Federal Reserve Fed Funds Rate was last at 1.0% several years ago, people everywhere were searching for yield, often with little regard for risk. [After today's rate cut, I suspect this will happen again.] I used to write for Suite101 at that time. I can't tell you how many times people asked me about high yield investments to get better return than "safe" treasuries and CDs. I often get emails today from my newsletter subscribers who think some new product might have better risk/reward than the safe investments I recommend for their core portfolios. For the lowest risk, I like US Treasuries when they are paying higher than current rates and CDs with FDIC. See My typical reply to questions is the higher the yield is above a US Treasury bond with the same term, the higher the risk (not counting CDs with FDIC which are also risk free.) Also, the increase in risk is not linear. If you get double the rate, you might be taking ten times the risk! I also wrote an article warning people about banks offering annuities with higher "teaser rates" so tellers had something to offer customers who complained about CDs renewing at very low rates. For the revised article, see:
Beware of Annuities
I also wrote an article telling people how to get better than advertised CD rates at their local bank. I've improved on this article over the years and you can read it here:
How to Get the Best CD Rates
Other people asked about investment products that paid eight to 12 percent a year returns that were related to real estate loans. As we have learned now, these products depended on people with low teaser rate mortgages paying the higher rates when the teaser period ended and their loans adjusted to very high rates, often nine percent or more. Very few would actually pay these high rates. They refinance or default in most cases. Anyone who bought these is probably very unhappy now as the return OF their investment is in doubt. They only wish they could have settled for low "returns ON investment" offered by treasuries five years ago.

The other investment to be wary of is high yield bond funds. These are often called "junk bond funds." I have NEVER liked these because your upside is limited by the interest rate compared to stocks which have unlimited upside. BOTH stocks and junk bond funds have the same downside which is bankruptcy for the company which makes the bonds and stocks nearly worthless. The bond holders usually get paid before shareholders with any assets available, but that is not much of a cushion for the average investor who was looking for 8% yield when treasuries were paying a few percent less.

Vanguard Fixed Income Funds:
  • GNMA Ginnie Mae Fund (VFIIX)
    • Seeks to provide a moderate level of current income.
    • Invests primarily in Government National Mortgage Association (”Ginnie Mae”) securities. These securities are backed by the U.S. government to provide timely payment of principal and interest.
    • Follows no specific maturity guidelines but typically maintains a dollar-weighted average maturity of 3 to 10 years.

  • TIPS or Treasury Inflation Protected Securities (VIPSX)
    • Seeks to provide investors inflation protection and income consistent with investment in inflation-indexed securities.
    • Invests in high-quality inflation-indexed bonds issued by the U.S. Treasury and government agencies as well as domestic corporations.
    • Maintains a dollar-weighted average maturity of 7 to 20 years.
    • Principal and interest payments are adjusted quarterly in response to changes in inflation.

  • Total Bond Fund (VBMFX)
    • Invests in more than 3,000 bonds representative of the broad, U.S. investment-grade market.
    • Goal is to keep pace with U.S. bond market returns.
    • Offers relatively high potential for investment income; share value tends to rise and fall modestly.
    • More appropriate for medium- or long-term goals where you’re looking for a reliable income stream.
    • Appropriate for diversifying the risks of stocks in a portfolio.

  • High-Yield/Junk Bond (VWEAX)
    • Seeks high current income.
    • Invests in lower- and medium-quality corporate bonds (“junk bonds”).
    • Fund’s bond holdings are considered speculative because of their issuers’ lower credit ratings, and they can fluctuate substantially in price.
    • Assesses a 1% redemption fee on shares held less than one year to discourage short-term trading

Vanguard Funds
NameSymbol
YTD Returns
as of
12/16/2008
Yield
500 Index Fund
VFINX 2.87%
–36.42%
GNMA Fund Investor Shares
VFIIX 4.71%
6.81%
High-Yield Corp Fund
VWEHX 13.90%
–28.00%
Inflation-Protect Sec
VIPSX 3.45%
–2.96%
Total Bond Mkt Index
VBMFX 4.56%
4.14%


Personally, I own the first three bond funds but not the last, Vanguard's High-Yield/Junk Bond (VWEAX). I much prefer to take my market risk with equities in both my core and my explore portfolios.





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