With the fixed income part of your portfolio, you have three options to choose from:  individual bonds, bond funds and ETFs.  Unknown to most people, holding actual bonds is not the same owning bond funds.  Once you understand the differences, you can determine which is best for you.  For the sake of discussion of this article, bond ETFs act similar to owning bond funds.  Let’s discuss the differences between them.

Return of Principal

Yes it’s true, both will give off income, yet if the bond market has a major decrease in price (which means yield rises), bond funds can lose a decent amount of principal. Bonds, if owned directly, you know will end at par value.  So while they may change in value during the holding period, the principal is returned at the maturity date.  The axiom of you only loose money when you sell definitely holds true to bonds.  You know if a bond returns 3.5%, and you hold till term, your return is exactly 3.5% when it matures. Assuming a default has not occurred, you get 100% of your principal.

Maturity Date

Bond funds do not have a fixed rate of maturity.  They are comprised of many bonds that are added or removed during the time you own the fund.  In 2008, during the financial crisis, the bond market took a major nosedive.  Most bond funds took a hit and experienced a substantial decrease in their NAV price.  A Motley Fool article that discusses this.  A TIPS ETF (iShares Barclays TIPS), what many would consider secure when owning the individual bonds, lost 10%.  Fortunately most bonds funds made a quick come back.

Income

With a bond fund income can vary, but typically pays out monthly.  This is because the underlying bond maturity date owned by the fund will vary during ownership.  Owning individual bonds, payouts amounts are known, and the dates the payouts occur.  By buying specific bonds you can determine when payouts will occur.

Diversification

When owning a bond fund, you don’t need a lot invested to be properly diversified.  When owning an individual bond you have default risk.  When you have only have $10,000 to invest, own only two bonds, and one defaults, you stand to lose 50% of your investment. Many individual bonds have a somewhat high dollar amount to invest in one bond. Ginnie Mae bonds, for example are usually sold in lots of $25,000.  To properly diversify with Ginnie Mae’s, this means you should have at least $200,000 – $300,000 to invest.  A beginning investor usually does not have that amount to invest, and a bond fund is usually a better choice.

Bond mutual funds have a SEC legal requirement to be a specific class of fund, they must invest at least 80%.  This leaves open the issue of the remaining 20% can be invested in other types of bonds, or even stocks!  This means while you wanted to invest in only short term (1 – 3 years) US Treasuries, the fund manager could be investing in riskier assets.  All the more reason to read and review the prospectus before investing.

Liquidity

Some bonds are more liquid than others.  Muni bonds are often very illiquid.  They don’t have a big market compared to the very liquid US treasuries. Meaning if you need to sell a bond before maturity, it’s somewhat harder to find a buyer.  The bid-ask price spread could mean you take a decent haircut on any potential profit.  During periods of market or issuer-specific stress, the lack of liquidity may result in price volatility. In some cases liquidity can disappear altogether for indefinite periods. On the other hand, if you own a bond fund you can sell at any time.

Fees

Individual bonds often bought through a broker.  When buying from a broker you not only have transactional costs, but you also run the risk of not getting the best price.  It’s typical of brokers to sell you a bond available in their their local inventory first than finding the best price on the open market.  Though these fees are a one-time deal they can eat into your profit.  With bond funds on the other hand, even if no-load, you have annual fees.  Bond mutual funds are managed by professional investors (either active or indexed based), which can be an advantage if you are a novice in managing individual bonds.  Specific sectors of the bond market it make sense to use an active manager.  Emerging markets bonds is one such example.

Summary

Bond or a bond fund depends upon your specific circumstances.  If you have less than $100,000 to invest, in most cases it’s best to own index based mutual funds or ETFs.  They offer the best way to diversify, get the proper asset allocation, and low in fees.  With some bonds, like US I Savings Bonds, you must purchase individually and cannot purchase through a mutual fund  No secondary market exists for them, and therefore cannot be owned by mutual funds.  With muni bonds, you are best to own bond funds since they are typically illiquid, and have a higher default risk than other government bonds.  Bond funds on the other hand, are subject to interest rate hikes and can be more volatile than owning individual bonds.

Related posts:

1. Why I Like US I Savings Bonds
2. Ginnie Mae Investing
3. Morningstar Review
4. Tax Efficient Investing

Lately I’ve been adding to our security investment bucket US I Savings Bonds or I-Bonds for short. In my opinion, they are a great bond to invest in, but often overlooked powerful tool in your investor toolkit.  The advanced investor or investment adviser often pooh-poohs them. They were created in 1998 as a method to keep up with inflation, and geared toward retail investors. I Bonds have some unusual and confusing aspects, so it’s best to understand them so you can use them to your advantage.

Composite Earnings Rates

I Bonds grow tax-deferred for up to 30 years, and are free from state and local taxation.  An I-Bond has two components to them and are added up to get the composite return:

• Fixed Rate – Remains the same for the life of the bond.  The fixed rate for newly issued I Bonds is announced on May 1 and November 1 of each year.  The rate applies to all I Bonds issued during that six-month period.
• Inflation Rate – Based upon CPI and is also announced every six months, on May 1 and November 1. This inflation adjustment applies to both existing I Bonds and newly issued ones, but the timing of that adjustment is dependent on the original issue date of any particular I Bond.

Fixed rates and semiannual inflation rates are combined to determine composite earnings rates. An I Bond’s composite earnings rate changes every six months after its issue date. For example, the earnings rate for an I bond issued in March 1999 changes every March and September.

If you would like to find the composite rates your bonds are earning, try our online Savings Bonds Calculator.

Here’s how the composite rate for I bonds issued May 2010 – October 2010 was set:

Fixed rate = 0.20%
Semiannual inflation rate = 0.77%

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
Composite rate = [0.0020 + (2 x 0.0077) + ( 0.0020 x 0.0077)]
Composite rate = [0.0020 + 0.0154 + 0.0000154]
Composite rate = 0.0174154
Composite rate = 0.0174
Composite rate = 1.74%

Interest accrues monthly and compounds semiannually.

Terms

• Both paper and electronic versions (through TreasuryDirect) are available, but a maximum $5,000 for each type per year per social security number.  This means a maximum of $10,000 can be purchased per social security number.
• They cannot be redeemed during the first year.
• After the first year to five years, if you redeem them early, you’ll get a 3-month penalty of the interest earned.
• Paper bonds are available in denominations of $50, $75, $100, $200, $500, $1,000, and $5,000

Pros and Cons

The reasons I like US I Savings Bonds:

• The interest generated is tax differed until you cash them out. No state or local taxes and only federal taxes are owed. They are perfect to use in taxable accounts as part of your bond portfolio and can be a means to extend your retirement accounts
• The fixed rate part of the bond is “fixed” for the term of the bond.  If the fixed rate rises in the future, just cash it out for a newer higher rate bond.
• They are multi-purpose since retirement accounts, 529 and alike are savings targeted for a specific goal.
• If used for higher-education (college) no taxes are owed. The bonds MUST be in the parent’s, not the child’s name.  There are other restrictions.
• The total interest rate cannot be less than zero, even during deflationary periods.
• Is more tax efficient than TIPS in taxable accounts.
• Since you are buying direct from the US Treasury, there is no markup fee from a brokerage house.

The disadvantages:

• The US government has currently a low fixed rate (0.20%), which isn’t as attractive as it was during the 2000′s.  Fortunately, you can “upgrade” your I Bond anytime after one year.
• You trust the BLS to accurately produce the inflation rate
• The inflation rate is only adjusted two times a year.  This may cause some lag in keeping up with inflation should it run rampant.
• No secondary market.  To redeem all bonds must be sold back to the US Treasury.
• If held for a short period (5 years) and in a high tax bracket it may offer poor returns after taxes.

I Bond Tips

A common trick to get around the $10k annual limit per social security number, is to have other family members purchase them in their name.  Keep in mind if used for higher education, in order to qualify for tax free, the I bond must be in the parents name.

Many family have bonds in their safe, in a safety deposit box, or somewhere scattered around the house.  A little known application is available from TreasuryDirect that allows you to manage your savings bonds with ease.  Their Savings Bond Wizard is a Microsoft Windows based application that allows you to enter, track and updates returns.  It will retrieve automatically the latest I-Bond rates.  The Savings Bond Calculator, is a web based app that can do similar calculations to the Windows application but online.  The biggest disadvantage is it does not offer a method to save, so every time you wish calculate your returns, you must re-enter each bond.

Buy US I Bonds the last day of the month.  This is because the interest accumulated is the same either at the first or the last of the month.  For the same reason, when selling you are best to sell at the beginning of the month.

I-Bonds Seriously?

Some may question my decision to invest in any US bond.  You’ve all heard about the mile-high deficits, the muted inflation rate, talk of possible double-dip recession and/or Japan-like 20 year deflation cycle. While recession is not completely out of the question, in my opinion would not be as severe compared to what occurred in 2008.  If we did get a long-term deflation death spiral, then at least the money invested would be the same as if I had kept it in cash.  This doesn’t help us with education expenses, since it has been increasing double the rate of inflation.  At best case scenario, and still think the most probable, higher inflation will occur than what we’ve seen the previous 30 years.   At one point I-Bonds, had a much higher fixed rate, and a much higher annual limit ($60k) than currently.  I am kicking myself now for not purchasing them 10 years ago, but I digress.

In the Investor Junkie family we are investing in I-Bonds because they can used for our children’s education, or for other expenses we may have in the future. We also invest in 529′s for our children, but I’m not completely sold on how effective they will be when they go to college.  I would rather hedge our bets, in case one of them does not go off to college, and keep our savings options open to other investments for them.

Additional Information

• TreasuryDirect – I Savings Bonds Rates & Terms
• Savings Bond Advisor – Great site about US Savings Bonds

Readers what other investments would you use that are not specific to education, but can be used for education tax-free?

Related posts:

1. Ginnie Mae Investing
2. Expect Even Lower CD Rates
3. The 4% Rule to Investing

Now that you know what is Ginnie Mae, lets talk about these factors:

• What kind of returns should you expect?
• How volatile are they (what’s their beta)?
• What risks do you have when investing?
• How can you invest in them?

Returns

Vanguard's GMNA Fund returns of $10k for the past 10 years (click for a larger view)

Ginnie Mae returns are outstanding when compared to other government bonds.  According to Morningstar, the Vanguard GMNA Fund has gotten an average 6.36% for the past ten years.  The 1, 5, and 15 year returns also show similar returns, so it’s beta is very low. As the graph shows above, if you invested $10,000 in January 2000, you would have almost doubled your money.  This is a perfect investment to add into your security bucket (fixed income) of assets.  At the moment, I have portion of my security bucket into a Ginnie Mae mutual fund.  Ginnie Maes are generating a much better return than other government bonds, CDs and money market accounts.  So you are getting a premium return compared to treasuries, yet getting the same default risk as a treasury.  What’s there not to like about Ginnie Mae bonds?  In my opinion, the rate spread doesn’t warrant the implied increased risk, and are good bet to place in your portfolio.

Risks

As with all bonds, they can suffer interest rate risk, and should always be part of your investment equation.  If the FED increases interest rates, the returns on Ginne Maes could decrease.  They also can have (albeit very low) default risk from the government.  The primary issue is when investing through mutual funds, because not all bond funds are alike.  According to the Washington Post, some Ginne Mae funds invested in other bonds, and got burned during the 2008-2009 stock market crash.  One fund lost over 5% in one year.  Granted, a mutual fund named GNMA legally must invest at least 80% into Ginnie Maes, but it’s the remaining 20% that’s the killer.  I always recommend using Morningstar to do your research.  Find out what other securities the mutual fund invests in, and at what percentage.

Investing

The minimum investment for a Ginnie Mae bond is generally $25,000. You can visit Ginnie Mae’s web site for more information.  Unless you are investing $200-300k to get proper diversification, I wouldn’t even consider that option.  Most people are best suited to invest via a Ginnie Mae mutual fund. The reasons are: better diversification and don’t have to buy/sell the individual securities. In my opinion, the two best funds are from Vanguard and Fidelity:

• Vanguard GNMA (VFIIX) – 0.23% expense ratio, $3000 minimum investment
• Fidelity GMNA Fund (FGMNX) – 0.45% expense ratio, $2500 minimum investment

Both have a low expense ratio, consistent performance, and a low minimum deposit requirement.  There are many other GMNA mutual funds available.  Do your research on Morningstar for others.  Currently there isn’t a Ginnie Mae ETF, and mainly because there isn’t an index to base the ETF upon. With active ETFs becoming more common, I suspect a Ginnie Mae ETF might be on the horizon.

Disclosure: I own shares of FGMNX.

Related posts:

1. The 4% Rule to Investing
2. Morningstar Review
3. Lending Club Review – How to Become a Bank
4. Review of “The Investor’s Manifesto” by William Bernstein

The Details

The book is a quick read, and is slightly under 200 pages.  Ron quickly dives into where we’ve been with a quick history lesson.  He then adds a dash of some rudimentary investor psychology.  Ron then allocates most of the book to discuss what opportunities he thinks exist in the future.  Ron states you should invest in these areas:

Whether you agree or disagree with the areas is a matter of opinion and it is fine to disagree.  Some of his ideas to invest aren’t bad in of themselves.  The concern I have is some of the content might be outdated in the six plus months when the book was finished.  With such timely information, Ron may have been better suited of pushing this out electronically as he was writing it. Another option, there are also many traditional financial magazines this content may have been better suited for.  What may have been a great area to invest in when he wrote the book, say for example financials, could be considered priced high at the moment this blog post is written.

The other concern I have is some of the generalized statements mentioned in the first two chapters.  He mentions:

While I believe it always pays to study the past, a quicker way to profit, in this market, is simply follow the pros . . . in the present.

While there is some truth to that statement, my question is what professionals do you follow? Which ones do you NOT follow?  If you are looking for professionals to aid in your investing, why not invest in them directly, ala a Bill Gross from PIMCO mutual funds?  If you believe in Warren Buffet, and his investing methodology, should you not just buy Berkshire Hathaway (BRK.B)?  Buying direct, so to speak, requires a much less thought process, and easy to implement.  Instead Ron goes the sexier route, and advises to pick stocks and mutual funds that the professionals are picking.  Again not necessarily a bad investment strategy, but doesn’t offer enough details to properly mirror an expert.  Included in the book is some basic market psychology, and does have some correct general assertions like:

Every investment is fraught with risk, although the riskiest time to invest, to be quite honest, is when investors are most complacent about the dangers of investing.

Ron does get into some specifics of sectors, and even specific stocks he’s invested in, in the past year.  He does present some good ideas, and valid arguments why they should be purchased.  He also discusses some advanced investing options that the average investor may not be able to easily take advantage of.

With its timeliness, I’m not sure if this should be in book form, and not in a multi-part Barron’s article.  Having the lag of six to eight months from writing till publication, we have a crystal ball to see how some of Ron’s predictions have worked out so far.  This can be a good or bad thing. Ron mentions in his book about Sam Zell and his Equity Residential REIT (EQR):

According to recent published reports, despite the troubles in real estate, EQR’s properties are 94 percent occupied and rents have been quite stable.  The dividend yield on EQR is above 8.5 percent return on your investment annually[.....]  The company has indicated it has no plans or reason to cut its payout – it has never done so since it came to market.

Whoops! Since this statement has been written EQR’s dividend has been reduced to 4.05 percent.  So far, not a great pick. It’s my opinion that REITs on the whole are not a good investment yet, and Ron may have jumped the gun on this one.  I believe more headwinds exist in the next year or so, and mainly for commercial real estate.  Though he is correct on this statement about REITS:

I say that the yield, or more precisely the dividend yield should not be too generous because, often, an extraordinary dividend yield could be a sign of trouble.

He should have taken his own advice, and applied it to Equity Residential.  His assumption is correct, and it applies today to REITs even in the traditionally “safe” range of 7 – 9 percent.

All is not lost with his book.  He does discuss  home purchases with the quote:

A home is not necessarily an investment, but it is the biggest single purchase you will ever make.  And there is never a good or a bad time to buy.   There are better or worse times to buy, based on market cycles…,this is among the best times in modern history to start building equity that you’ll have for your golden years.

His is clear that the  primary residence is not a piggy bank, and applaud the honesty he treats the subject.  He states it should be looked at as an asset that more than likely will rise in future years.  Obviously purchasing a primary home is very location specific and a personal decision.  What might be a great time to buy in say Dallas, might not make sense yet in New York City.  Bottom line you buy a house to live in with the prospects it should increase in value over time.

In Summary

Ron’s book while not bad, it may have been better suited in some financial magazine or online publication.  Some of his content contained very timely investment ideas.  What may have been a great opportunity eight months ago, may not exist today.  He does have some interesting ideas, and the book can be perused for areas to invest into.

My Rating: 2 1/2 out of 5 stars.

Disclosure: Book courtesy of TLC Book Tours.

Related posts:

1. Morningstar Review
2. Review of “The Investor’s Manifesto” by William Bernstein