Bond strategy

You might want to consider preferred stocks. PFF would be an ETF that might work for you.

You might want to buy individual preferred stocks for a taxable account because some some of the stocks in PFF aren't fully qualified which is needed to get a tax break on dividends.

-- Ron

The 401K only has one bond fund, that's a Lehman Aggregate Index. Its average maturity is about 7.5 years as I recall.

What does the length of bond maturity mean to me when investing? My 401K has short and intermediate term bond funds,,,,,,,,,

DTW .../\.../\.../\...

======================================= MODERATOR'S COMMENT: Please trim the post to which you are responding. "Trim" means that except for a FEW lines to add context, the previous post is deleted.

With longer maturities, you get more interest rate risk but also higher returns. So you can model the formula something like so:

short bonds = risk 1.25 int bonds = risk 1.5 equities = risk 10

If you want a risk level of 8, you can choose either:

1.25x + 10(1-x) = 8 or 1.5x + 10(1-x) = 8

In the end, the overall risk level is still 8. But because you don't have access to safer short-term bonds, you use int-term bonds instead and then reduce the equity percentage to compensate for riskier bond holdings.

If I was only considering tax reasons, my placement preference would be:

1) 401K/IRA 2) Vanguard Variable Annuity 3) Tax-Exempt Bond Fund 4) Taxable Account

Something to think about, thanks.

Hmmm, I hadn't considered that for bonds. Looking at Vanguard, their short-term investment grade corporate annuity isn't all that expensive. The ER is .45%, while the similar mutual fund is .21%. The only ETF they have for short-term bonds seems more weighted to Government than corporate, but is lower fee of course.

I have the problem that I don't want to let the tax tail wag the investment dog, as I've seen mentioned, if it's detrimental to the overall portfolio.

My original strategy was to treat the two accounts totally separately, as that's the easiest approach. I don't want to complicate things too much, as I'm likely to get confused.

Brian

I'll take a look at it, thanks.

Ok.

Brian

In *very* brief: longer term indicates greater sensitivity to interest rate fluctuations - rates go up, present values go down. Longer term bonds will have higher price volatility.

In slightly less brief: maturity isn't really the relevant question, but rather, "duration" - which is a measure of the sensitivity of the bonds values versus interest rates.

Note that things like floating-rate bonds often have durations which are very very small, yet maturities which may be long. So if you're concerned with interest rate risk, note the duration, not the maturity.

Duration, like maturity, is usually quoted in units of time - years. I was just looking at the portfolio details of a muni bond fund this morning which had an average maturity of 23 years and an average duration of only about 5.5 yrs.

Re: the earlier poster who asked about a Lehman Agg Index fund: While the average maturity of the Agg is now around 7.3, the duration is around 4.6 and the average credit quality is very high - only about 20% is corporate debt and even that is all "investment grade" debt. The rest is treasuries and government-related (ie. agencies) and high-quality asset-backed (ie. FNMA conforming mortgages - none of the subprime structured stuff). Assuming the expenses are low, it's exactly what's typically meant by "the bond market" for asset-allocation discussions. As far as fund categories goes, it's "intermediate-term bonds," not long-term.

One comment - the old expression is, don't let the tax-tail wag the dog. The point isn't to avoid taxes, it's to maximize after-tax returns. Your choice of where to hold different types of investments may be driven more by growth assumptions.

Example...pretend you don't want REITs at all and you want to figure out how to use $10k of Roth "capacity". Would it make sense to hold your bonds in the Roth? Probably not. Let's say these are your return expectations for $40,000 that you're investing today, after some undefined period of time, "gross" of tax drag:

$10,000 invested in bonds will grow to $13,000 $10,000 invested in (some aggressive asset class) will grow to $35,000 $10,000 invested in large-cap US stocks will grow to $22,000 $10,000 invested in international stocks will grow to $23,000

So you'll start with $40,000 today and end up with $93,000. Now..is it better to use the Roth for your bonds, to avoid being taxed on the interest? Or on "some aggressive asset class", to avoid tax on gains and income? It'll depend on your assumptions about "tax drag" along the way but that's a lot of ground to make up. If I was going to have $93k I'd rather have $35k of it in a Roth than $13k in a Roth.

-Tad

Sounds like you wouldn't feel too bad about that being the sole US bond component, is that right?

The total projected expense ratio for the fund in the 401K is 0.0810%, nice and low. I think I mentioned before, that includes management expenses plus transaction/processing/etc. costs.

Brian

Duration starts with the maturity of a given bond, and mathematically accounts for the reinvestment opportunity for the coupon. For what it's worth, a zero coupon bond due in X years, has a duration of precisely X. A tiny coupon will reduce the duration, a high coupon reduce it a lot.

A fund with a duration of, say, 5 years, will go up or down by about .5% for each move in rates of .1% or very close to this number.

JOE

If the asset class you're looking for is "the bond market" (or, more accurately, "the *US* investment-grade bond market") that's exactly it. Especially if you're looking for index-fund representation of those asset classes. There are, of course, actively managed bond funds, but it's awfully hard to generate excess returns and overcome management fees in investment-grade bonds.

That seems a touch low, but not impossible - Vanguard's institutional share class of their "total bond market fund" - basically exactly this - is 7bps. (their investor shares are 20bps and admiral shares are 11bps)

I've seen some discussion that there's no need to go outside of treasuries for "bond market exposure" in some asset allocation plans - but this would do just fine for the vast majority for exposure to that.

If the duration seems a bit long, just moderate it with some cash or GICs or whatever short/ultra-short option you have in the 401k. (Assuming it's a similarly decent fund and not invested in structured deals backed by subprimes...).

If, for example, you wanted 40% bonds in your portfolio but wanted the bonds to have half the duration of the Agg, you could go 20% Agg and 20% cash.

Can you tell us exactly which funds you do have available in that 401k? (If you posted them already, I must have missed them)

I suppose so. I'm just a guy trying to get his head around a reasonable asset allocation and get the investment house in order. That way things can be a bit more automagic. The advice I'd read said to stick with shorter term bond exposure.

It's right out of the "fee matrix" sheet for all the funds. They tend to be pretty low, one of the good things about the plan.

Annual Fund Other Per Management Fees Expenses Total $1,000 Bond Market Index Fund 0.0120% 0.0690% 0.0810% $0.81

What we have is a "Stable Value Fund":

"The Fund is invested in interest-bearing contracts or other arrangements issued by insurance companies or other financial institutions."

It has a fixed return rate adjusted each quarter, currently 5.12%.

I'll start a separate reply for that, to keep this message shorter. I replied earlier but it bounced for length, mostly due to inadequate snippage.

Brian

Here's the available funds with their projected expenses out of the fee matrix:

Fund Annual Management Other Per Fees Expenses Total $1,000 Lifecycle Funds: Lifecycle Retirement Fund 0.4900% 0.0671% 0.5571% $5.57 Lifecycle 2010 Fund 0.4900% 0.0543% 0.5443% $5.44 Lifecycle 2020 Fund 0.4900% 0.0489% 0.5389% $5.39 Lifecycle 2030 Fund 0.4900% 0.0602% 0.5502% $5.50 Lifecycle 2040 Fund 0.4900% 0.0646% 0.5546% $5.55

Index Funds: Bond Market Index Fund 0.0120% 0.0690% 0.0810% $0.81 Balanced Index Fund 0.0110% 0.0516% 0.0626% $0.63 (S&P 500 Index Fund [60%] Bond Market Index Fund [40%]) S&P 500 Index Fund 0.0100% 0.0402% 0.0502% $0.50 International Index Fund 0.0350% 0.0817% 0.1167% $1.17 Russell 2000 Index Fund 0.0220% 0.0378% 0.0598% $0.60

Actively Managed Funds: Stable Value Fund 0.1731% 0.0394% 0.2125% $2.12 Large Companies Value Fund 0.2400% 0.0400% 0.2800% $2.80 Large Companies Core Fund 0.3000% 0.1893% 0.4893% $4.89 Large Companies Growth Fund 0.3600% 0.0458% 0.4058% $4.06 Large Companies International Fund 0.4500% 0.1808% 0.6308% $6.31 Small/Mid Companies Value Fund 0.5800% 0.0499% 0.6299% $6.30 Small/Mid Companies Growth Fund 0.7300% 0.0454% 0.7754% $7.75 Science & Technology Fund 0.5625% 0.0395% 0.6020% $6.02

Other: Company Stock Fund 0.0112% 0.0373% 0.0485% $0.48

Brian

Right, and that's the situation I'm in, trying to figure out which assets fit best in the various accounts.

Which investments did you have in mind that would be preferable over bonds in this case?

Brian

[sounds about right, and fees seemed like you'd said]

That'd be it. Stable Value is, for asset-allocation purposes, the same as "cash" or a money market fund. It'll throw off interest comparable (perhaps a touch higher) than money market funds, and, as the name implies, the value is stable - it has a duration of zero - rates go up, rates go down, the value of your investment in it won't change - just the interest rate.

Anyway, your whole "bond market" allocation could easily be just the combination of that Leh Agg Index + the stable value fund -- in whatever proportion you want in order to adjust the duration down anywhere between zero and the full dur of the agg.