Question: For the next two years I plan on working part-time so that I can spend more time with my children. I plan on investing an inheritance of approximately $300,000 cash into bond fund (s) to supplement my part-time income. I’d like to make close to 5%. I’ve done some research on bond funds and have found some that look good. My question is should I put it all into one fund or should I spread it out into different bond funds?
Answer: It sounds simple to invest your money in a bond fund yielding 5% to supplement your income. Let’s look at why that can be risky, and then I will make a suggestion.
By investing in a bond fund, you are diversifying away the kind of risk you would take if you just bought an individual bond. But you are not diversifying away interest-rate risk, which depends on the type and duration of the bonds in the fund and any changes in market interest rates. Remember, bond prices fall when interest rates rise. Here is a real-world example of interest rate risk.
On May 1st of this year the 30-year U.S. Treasury rate was 2.88%. Five months later, on October 1st that rate had increased to 3.68%. Over the same period of time, the share price of the Vanguard Long-Term Bond Index ETF (Symbol BLV) fell from $95 to $83, a drop of over 12.5%. On May 1st, BLV paid an annualized dividend yield of 3.8%. Five months later, on October 1st, its annualized dividend yield had increased to 4.7%.
In other words, over the last 5 months an investment in long-term bonds dropped by over 12.5% and it’s dividend yield increased by 24%. If you had invested your $300,000 in that fund on May 1st your principal would be down to $262,105.
My advice to you is to divide your $300,000 inheritance into two accounts. Label the first account “short-term” and the other “long-term.” Figure out how much money you will need to supplement your income while working part-time. Put that amount into your “short-term” account. Invest that money in a liquid account like a liquid CD or a money market account. You can draw this account down to zero over two years.
Put the rest of the money in the “long-term” brokerage account. Make a list of goals for that money, such as retirement, college education, etc. Invest that account for long-term growth. Allocate the assets into at least six different asset classes: Large U.S. Stocks, Small U.S. Stocks, International Stocks, Developing Markets Stocks, Real Estate Investment Trusts (REITS), and short-term bonds. Choose one or more index funds to represent each asset class. Determine the percentage of assets that you will allocate to each asset class by examining the rate of return you would like to achieve and the volatility you are willing to accept.
Do some research on how to build a mutual fund/ETF portfolio. Then examine your portfolio quarterly. Keep track of the asset allocation. If it gets out of whack, rebalance it. If your goals change, reexamine your asset allocation.