Bond fund question

I'm looking at Vanguard's California Tax Exempt bond fund as a place to
park some short term investment money as an alternative to a money
market. Right now, I can maybe get around a 3% return on a money
market at my bank. But looking at my tax bracket, and the history of
VCTIX, it seems like an attractive alternative.

Are there any restrictions with bond funds as far as selling shares?
Or can I buy/sell just like a regular stock mutual fund? It seems like
it works just the same.

I don't plan on using this money any time soon (maybe a 5 year
horizon)--but I'd like to be able to pull it out if necessary. I'm
assuming I can sell bond fund shares whenever I want?

Is it ever likely for these bond funds to have negative returns? Sure
they can underperform other investments, but unless the bond manager
starts dumping low interest rate bonds like crazy when rates shoot up,
I suppose bond funds are fairly risk-adverse? (Hence it's my reasoning
to use them for short-term investment dough)

Re: Bond fund question

Before you invest, make sure you understand the duration of the bond
fund. Search google with term "Bond Duration". Duration of VCTIX is
6.5 years. Consider yourself warned.

Re: Bond fund question

wrote:

> I'm looking at Vanguard's California Tax Exempt bond fund as a place to
> park some short term investment money as an alternative to a money
> market. Right now, I can maybe get around a 3% return on a money
> market at my bank. But looking at my tax bracket, and the history of
> VCTIX, it seems like an attractive alternative.
>
> Are there any restrictions with bond funds as far as selling shares?

You need to read the prospectus for the fund, to see if there are any
restrictions on how soon you can sell the shares.

But you have to remember that the share price will fluctuate in value,
unlike the money market account at your bank. That means that when you
finally sell the shares of your bond fund, they might be worth less (or
more) than what you originally paid for them. That means you always
have a principal risk--you may not get your entire principal back.


> I don't plan on using this money any time soon (maybe a 5 year
> horizon)--but I'd like to be able to pull it out if necessary. I'm
> assuming I can sell bond fund shares whenever I want?
>
> Is it ever likely for these bond funds to have negative returns?

The total return is a combination of the yield and the capital gain (or
loss).

So it's always possible that the capital loss could be more than the yield.

I have a feeling you don't understand that with a bond fund, your
principal fluctuates--it's not stable.


--
Steven D. Litvintchouk
Email:

Remove the NOSPAM before replying to me.

Re: Bond fund question

I know what you mean. Looking at the charts on VCITX, it doesn't seem
as stable as I previously thought. It seems like for my purposes, it
might make more sense to either stay in a money market, or buy an
actual muni bond itself.

I was assuming because of a bond fund's investment in bonds, not
stocks, the downside may be somewhat limited. Sure, still a gamble,
but I figured it was a bit less of a risk for short term investing than
a stock fund.

Re: Bond fund question

wrote:
>
> I know what you mean. Looking at the charts on VCITX, it doesn't seem
> as stable as I previously thought. It seems like for my purposes, it
> might make more sense to either stay in a money market, or buy an
> actual muni bond itself.

A five year AAA Calif. muni now yields about 3.3%, so that might not be
a bad idea. There are several considerations you need to keep in mind
about investing in individual bonds, though. This is not meant to say
that you shouldn't buy a muni bond, but rather that you should do it
with your eyes open.

You'll be highly non-diversified. Even though the chance of the bond
defaulting is extremely small (assuming AAA rated), you stand to lose a
lot if that unlikely event occurs. That's why the usual recommendation
is not to invest in individual munis with less than $100,000 (so that
you can invest in several different bonds).

You were talking about having liquidity - that you'd like to be able to
pull money out if necessary. A bond fund can go down in value because
the bonds it holds lose value. So if you hold the bond directly, it can
go down in value as well. Holding an individual bond rather than a fund
doesn't protect you from possible losses if you have to sell before
maturity. And you'll have to sell the whole bond, unlike a mutual fund,
where you could sell just what you needed.

You will also have to deal with where to put the interest payments. In
a fund (or bank account) you can automatically reinvest the interest.
You can't do that with a bond. You'll have to dump the interest into
your bank account, or spend it, or ...

I think individual bonds are a fine idea if one has a target date in
mind, when one will need the money. Or, as a part of a fixed income
portfolio. But you need to consider whether a bond's degree of
flexibility meets your needs, especially if you want to use a bond as a
substitute for a cash account.

A suggestion that is often made as a way to increase yield from MMFs and
MM accounts is ultra-short bond funds. For money that you won't need
for a few years, you can go a little longer in duration, with short term
bond funds. This Morningstar article goes through all of this for you:


Just to add a little to that article ...

Some of the best yielding no load national and California muni funds
are:

American Cent Calif Int Term Tax Free (3.67% yield, 4.6 year duration)
Vanguard Calif Int Term Tax Exempt (3.59% yield, 4.9 year duration)
Wells Fargo Advantage Short Term Muni (3.06% yield, 1.6 year duration)
Vanguard Ltd Term Tax-Exempt (2.78% yield, 2.3 year duration)
American Cent Calif Ltd Term TaxFree (2.71% yield, 2.7 year duration)
Wells Fargo Advantage Ultra Short Term(2.49% yield, 0.6 year duration)
PIMCO Short Duration Muni (2.41% yield, 2.2 year duration)

The Wells Fargo funds until recently were Strong funds. The Ultra Short
Muni gets its relatively high yield (for such a short duration) by
taking on additional credit risk - its average bond is rated A. The
other funds average AA-rated bonds, except for the Vanguard Calif
Intermediate Term fund, which is AAA rated.

The higher the duration, the more volatile the fund is likely to be.
So, the more one wants to think of these funds as cash replacements, the
lower the duration one wants.

Finally, there is always Vanguard's Calif Tax Exempt MMF, currently
yielding 2.22%. The after-tax yield of a taxable fund is about 2/3 of
the pre-tax yield (assuming 25% federal tax, 9.3% Calif. tax, and
itemized deductions), so even this beats the 3% you are getting now.

--
Mark Freeland

Re: Bond fund question

Wow--thanks a lot for this info!

I was always wondering what exactly the average bond duration had to do
with the fund's performance. That's why I thought there might have
been some kind of restriction as to when you could sell a share
(somehow linked to the bond duration).

So I guess the shorter the term of the bond, then the more likely the
manager can either hold until maturity or sell with minimal interest
rate depreciation on the bond's value.

These ultra shorts look pretty good as an MMF replacement--I'll
investigate these funds.

Thanks!!

Re: Bond fund question

wrote:

> Wow--thanks a lot for this info!
>
> I was always wondering what exactly the average bond duration had to do
> with the fund's performance. That's why I thought there might have
> been some kind of restriction as to when you could sell a share
> (somehow linked to the bond duration).
>
> So I guess the shorter the term of the bond, then the more likely the
> manager can either hold until maturity or sell with minimal interest
> rate depreciation on the bond's value.

You are correct.


>
> These ultra shorts look pretty good as an MMF replacement--I'll
> investigate these funds.

In fact, ultra-short bond funds were the only bond funds to provide a
positive total return even in 1994, when interest rates rose steeply.
The interest rate rose enough to more than compensate for the decline in
the share price. Whereas even short-term bond funds had a negative
return that year.

But if interest rates continue to rise over the next 5 years, then even
the total return of ultra-short bond funds, while positive, will still
lag the total return of money-market funds or bank money market
accounts--since those have little or no principal risk.

If I thought that interest rates were going to rise and rise and rise,
like in the 1970's, I wouldn't invest in anything but money market funds.


--
Steven D. Litvintchouk
Email:

Remove the NOSPAM before replying to me.