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Asset classes for ST bond portion of portfolio?

[Mods: I realize this is getting near the line of misc.invest.mutual-funds, so if it helps, think in terms of narrow asset classes :]
VFSTX is a short-term investment-grade corp. bond fund VFIIX in a GNMA fund BSV is an index ETF tracking the Barclays 1-5 year Govt/Credit Float Adjusted Index (a total-market index within its maturity box, is 70% Treasuries) CSJ is an index ETF tracking the Barclays 1-3 year Credit Bond Index (a corporate-only index) AGG is an index ETF tracking the Barclays US Aggregate Bond Index (a total-market index, so 33% Treasuries and 30% MBS passthroughs)
BSV VFSTX VFIIX CSJ AGG SEC Yield 0.84% 1.56% 3.17%(*) 1.05% 2.28% Dist Yield 1.90% 2.73% 3.25% 1.99% 3.48% YTM 1.10% 1.60% 3.10% 1.28% 1.86% Duration 2.6yr 2.3yr 3.6yr 1.84yr 4.31yr
(*) fund uses the "BASED ON HOLDINGS' ACTUAL INCOME FOR THE PAST 30 DAYS" method of computing SEC yield, rather than the "BASED ON HOLDINGS' YIELD TO MATURITY FOR LAST 30 DAYS" method
So, any thoughts on which to use for the short to short-intermediate term bond section of a portfolio?
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Rich Carreiro                            rlc-news@rlcarr.com
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Rich Carreiro
Rich Carreiro writes:
Last I looked, it's actually about 2/3 corporates and 1/3 treasuries. The corporates are benchmarked to the BarCap 1-5yr credit index, so that part of this fund may go out further on the yield curve than does CSJ, which should help the yield up a bit even while the big treasury holdings are pulling it down a bit. It's a nice compromise, but bear in mind that this is an actively managed fund and the managers can make choices like, say, going to a (slightly) lower credit-quality part of the market at least for the corporates. (no comment on the quality of the notion "credit quality" these days).
Fabulous fund, but it's a different animal. Mortgage backed securities behave differently from traditional fixed income securities. They all have an embedded call option which lets the borrowers pay back their loans any time along the way, and the borrowers do - when interest rates go down (not very likely right now, of course), borrowers refinance - they give you back your capital at exactly the time when you don't want them to. And when rates go up - just when you do want your principal back early, they stop doing that. These conditions lead to what's known as "negative convexity" and it has important implications for what happens to the prices of these securities when rates move. Basically, no matter which way rates move, it's not what you want. The up-side is that you get relatively great current yields and low credit risk in exchange for those unfortunate interest-rate risk effects. I'd lean towards putting this fund into a portfolio geared towards generating current income, but if you're not pulling current income out and/or are managing a portfolio with an eye towards total returns, it may not be the best choice (though, again, with yields on traditional fixed income where they are, it's not clear that there are any great choices right now anyway).
Similar to VFSTX, but not actively managed, and probaly with higher current credit quality (and thus, as you noted, lower current yields)
More interest-rate risk here, but it may be worth the risk for the higher current yields.
Swedroe wrote a good piece back in April about why hugging the short end of the curve while waiting for rates to rise might not make sense. Basically, the deal is this - the difference in yields may be enough that even if rates do go up, the cap losses due to interest rate risk may be offset or more than offset by the yield you've been collecting along the way. To illustrate with your numbers below (and assuming that prices move perfectly linearly with respect to rates and durations - which they don't)
If rates all go up by 1% two years from now (and that, too, is quite an set of assumptions, too), then your investment in, say, BSV, may go down by 2.6%. Meanwhile, you've collected your 0.84% yield for two years and your total return over those two years may be around -0.92% - a loss of about a percent. Now suppose you'd had the same money in AGG: You've pocketed your 2.28% for two years (I'm using SEC yield here, just for illustrations sake), so 4.56% in your pocket before the interest rate move knocks 4.31% off your fund's price at the end, leaving you with 0.25% total return. You come out ahead - even with a 1% rise in rates over two years, by more than a full 1% with AGG. Of course you were taking more risk along the way - rates could have moved by 2% or more. But it's worth thinking about.
It depends, I think, on more than just these yields - I think you need to consider what the portfolio is *for* - for example if you're retired and pulling current income, you may want a different position from if it's part of a long-term not-touching-it-for-20-years retirement portfolio, which would, also, be different from a portfolio where you're trying to preserve your assets with as little risk as possible for, say, a big purchase a year or two from now.
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David S. Meyers, CFP(R)
http://www.MeyersMoney.com
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David S Meyers CFP
David S Meyers CFP writes:
[a really excellent post]
In my case it's the second one -- "part of a long-term not-touching-it-for 20-years" portfolio.
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Rich Carreiro                            rlc-news@rlcarr.com
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Rich Carreiro

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