Question: I plan on investing an inheritance of approximately $500,000 cash into a bond fund(s) to supplement my income. I’d like to make close to 4% and know that puts me in the moderate risk category. I’ve done some research on bond funds and have found some that look good. How much risk am I taking by investing in bond funds? Should I spread the money out into different bond funds or other investments? Thanks for your input.
Answer: It sounds easy to invest your money in a bond fund yielding 4% to supplement your income. Let’s look at why that can be risky, and then I will make a suggestion.
By investing in a well-managed bond fund, you are diversifying away the kind of risk you would take if you just bought one 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.
For example, if the bond fund invests in long-term bonds that are yielding 4% today and the long-bond market interest rate moves up to 5%, your principal will go down considerably. That’s interest rate risk! So even though the fund has a positive yield of about 4%, it can go down in value.
You can reduce the amount of interest-rate risk by investing in short-term bonds or short-term bond funds, but today’s short-term bonds have lower yields than long-term bonds. You pay for the extra return of long-term bonds by accepting the interest-rate risk.
To help you chose what type of bond fund to invest in, go to Morningstar.com. They provide a popular service with mutual fund and exchange-traded fund (ETFs) data and analysis. Morningstar breaks bonds into four general categories: government, corporate, securitized, and municipal. Each of these four categories is further divided into multiple subcategories.
With current interest rates so low, my advice to you is to break your $500,000 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 for the next few years. That will be how much you put in your short-term account. Invest that money in short-term CDs or a money market fund. You can use this account for your cash needs and replenish it later from your long-term account.
Put the rest of the money in a long-term 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 five different asset classes: large-company U.S. stocks, small-company U.S. stocks, international stocks, developing markets stocks, and bonds. Choose one or more low-cost mutual funds to represent each asset class. Determine the percentage of assets that you will allocate to each asset class by doing some research or getting help from a professional.
Keep in mind the rate of return you need and the volatility you are willing to accept. Then review your portfolio quarterly. Keep track of the asset allocation. If it gets out of whack, rebalance it. If one or more of the mutual funds doesn’t match your expectations, make a change. And if your goals change, reexamine your asset allocation.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.