Believe it or not, some people have lost confidence in the stock market, and the recent net outflow from equity mutual funds reflects this collective feeling. Some may be spending or investing their money elsewhere for reasons that make perfect sense, but I suspect that many are simply no longer placated by the historic rewards of taking the "long view." So, what are the options for someone who jettisons their stock funds so they can finally get some sleep at night?
Short-term bond funds and GNMA funds come to mind as relatively safe havens for people looking for alternatives to 0 percent money market funds and CDs paying next to zero. The advantage of either a short-term bond fund or GNMA fund is that each is paying a rate that is comparable or better than today's rate of inflation. While inflation is a little different for everyone, depending on how we happen to spend money, the current rate is about 2 percent.
Short-term bond funds invest in bonds that will mature, on average, within about three years. These funds are currently paying interest at a yield of 1.62 percent. GNMA funds invest in government-guaranteed bonds backed by the Veterans Administration or the Federal Housing Administration. These funds are currently yielding about 3 percent.
For someone not familiar with how bond funds operate, it is more comforting to just walk into a bank and plunk any significant amount of money into a CD. The principal is
A bond fund with a portfolio of bonds is paying an interest rate based on the average monthly interest paid on all the bonds in the fund.
At the same time, the capital value of a bond fund investment can fluctuate from day to day just like a stock mutual fund. However, the underlying reasons are entirely different. Like a rope on a pulley, the capital value of our existing bonds will drop temporarily if interest rates out in the bond market go up. Or, the capital value of the bonds in our bond fund will go up if interest rates in the market go down.
Over time, the bonds in our fund, one by one, reach maturity and get replaced with new bonds that pay the new prevailing rate. Any change in capital value slowly goes away as this happens and the fund returns to the norm -- which is basically the price at which we bought it.
Short-term bond funds turn their bonds over so quickly that not a great deal of capital value changes happen. At the same time, a change (up or down) in interest rates is soon reflected in most of the bonds owned by the fund. The measurement of the effect of this change is called "duration" and a typical short-term bond fund has a duration of 2.7. This means that for every full percentage point that interest rates rise in the bond market, the drop in capital value will be 2.7 percent for the short-term bond fund.
So, for someone who can live with temporary and slightly fluctuating capital values, there are opportunities to earn more money than would be possible with traditional CDs and money market funds. With inflation at 2 percent and a money market fund paying nothing, it's costing 2 percent, effectively, to have a financial institution watch over our money. A little capital fluctuation is a cheap price to pay for at least moving forward. Fidelity and Vanguard both offer both types of funds.
Steve Butler is CEO of Pension Dynamics. Contact him at firstname.lastname@example.org or 925-956-0505, ext. 228.