Archives for April 2013

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Is My Emergency Fund Too Big?

A reader writes in, asking:

“We’re in an unusual position: We have no debt (including no mortgage), no kids, and live well well below our income. Should everything extra go into investments? I don’t suppose it’s reasonable to say I have $100K in an ’emergency fund’?”

Unless your bank is paying you an unusually high interest rate*, I don’t see a lot of benefit to keeping a six-figure sum in cash. Even if you have a very low risk tolerance and are on pace to meet your goals with modest returns, there are a handful of investment options that are very low risk and likely to earn more than typical savings/checking accounts.

CDs, for example, can be a good choice. Allan Roth has often written about finding long-term CDs with low penalties for early redemption (e.g., Ally Bank’s CDs). That way you can get the (relatively) high yield of a long-term CD while still being able to break the CD to reinvest the money at a higher rate if rates rise. And if you stay under FDIC limits, credit risk is virtually zero.

Or, as we discussed recently, I Bonds are currently guaranteed to keep up with inflation (before taxes, that is). Like CDs, I bonds have basically no credit risk. And because you redeem I Bonds directly rather than selling them on the secondary market, there’s basically no interest rate risk either.

A TIPS fund can make sense in some cases, but the downside here relative to I Bonds is that the (inflation-adjusted) yields are negative all the way out to 20-year maturities (as of 4/5/13). And if you go further out along the duration spectrum, you take on significantly more interest rate risk.

We’re in an odd place these days where the distinction between emergency fund and normal bond holdings is becoming rather blurred, given that the typical emergency fund candidates (e.g., CDs, I Bonds) have yields roughly as good as (and sometimes even better than) the typical choices that would be used for the bond portion of a portfolio.

*My favorite place to shop for rates is the Deposit Accounts website. I often find that they have a more thorough collection of rates than many other sites that appear to primarily just pitch banks that pay a commission.

Using High-Dividend Stocks as a Bond Substitute

In reply to last wednesday’s article about low bond yields, a few readers wrote in with similar questions. Here’s one:

With bond fund yields so low (less than 2% on Vanguard’s Total Bond as you stated), should investors consider allocating a modest portion of their bond allocation to stable large cap stocks that offer a dividend of 3%+? Seems like this would be a worthwhile risk.

I think it’s easiest to break this question down into two separate pieces:

  1. How differently do large-cap high-dividend stocks perform than the rest of the stock market, and is there something in those differences that makes them particularly useful as a bond substitute?
  2. Might it make sense right now to shift a portion of the portfolio from bonds to stocks?

With regard to the first question, I think the following Morningstar chart is interesting. It shows the performance of Vanguard’s High Dividend Yield Index Fund (in blue) as compared to Vanguard Total Stock Market Index Fund (in orange) and Vanguard Total Bond Market Index Fund (in green) since the inception of the High Dividend Yield Fund in late 2006. (Click the image to see it in full size.)

MorningstarHighDividend

If Vanguard’s High Dividend Yield Index Fund (with its Morningstar classification as large-cap value and its yield of 3.04%) is a good representation of the type of large-cap high-dividend stocks you have in mind, then I think it’s clear that such stocks are still more like other stocks than they are like bonds. That is, the high dividend yield does not make them noticeably less risky.

With regard to the second question — shifting from bonds to stocks in general — I think for most investors such a shift is a dangerous idea.

With bond yields well below historical averages, it’s true that we should expect lower-than-historical-average returns from bonds in the near future.

However, the best predictor I’m aware of for long-term stock returns is the PE10 ratio (a.k.a. Shiller PE), and right now, that ratio is somewhat higher than the long-term average (see here), which suggests lower-than-historical-average returns for (U.S. large-cap) stocks as well.*

In other words, while bond yields are crummy right now, stocks aren’t exactly a red-hot bargain either.

And, more importantly, even if an investor comes to the conclusion that stocks are a decidedly better bargain than bonds, there’s the question of risk tolerance. If the investor’s portfolio was already set so that its risk level was as high as the investor’s tolerance could handle, then bumping up the risk doesn’t make sense. So it is only the unusual investor with excess (i.e., currently-unused) risk capacity for whom shifting further into stocks could make sense.

*While PE10 works better than other stock market predictors, it’s important not to place too much faith in this ratio. According to Vanguard’s research, it has almost no predictive power over short periods. And even over long (10-year) periods, it predicts less than half of stock return variation.

Should You Be Scared to Own Bonds?

In the last week, I’ve received a few emails from readers who were concerned about a recent MSN Money article. The following snippet sums up the main message of the article:

“In just the past four years, investments into bond mutual funds have doubled to $4 trillion. But this perceived bastion of safety is more like a ticking time bomb waiting to explode. And when it does, it will devastate any portfolio with a heavy allocation to Treasury bonds.”

Scary language. But based on the portfolios I see most often, I don’t think most investors need to be scared about anything that could be referred to as a bond explosion.

Bond Bubble Fears

It’s true that interest rates are currently very low, and it’s true that bond prices go down when interest rates go up. But there’s no telling when interest rates are likely to rise. They could fall first (though not very far) or stay right where they are for an extended period of time.

In addition, with short-term or intermediate-term bonds, the losses would be very unlikely to approach anything like the losses that can occur in the stock market.

For example, Vanguard’s Intermediate-Term Treasury Fund has an average duration of 5.2 years. Even if rates rose by 3% overnight, that’s only a ~16% decline in price — not even close to what can happen to stocks in just a run-of-the-mill bear market. And most of the the time, rates don’t increase overnight. Instead, they increase over a period of time, during which an investor in a bond fund will be earning interest that will help to offset any declines.

By way of analogy, if the popping of a stock bubble is like the popping of a birthday party balloon, the popping of a bond bubble is like the popping of a bubble on a sheet of bubble wrap.

That said, there’s no reason for bond investors to be particularly optimistic.

Realistic (Low) Expectations

In a webcast last week, Ken Volpert (the head of Vanguard’s Taxable Bond Group) suggested not to expect returns of more than 1.7% or so from Vanguard’s Total Bond Market Index fund for the near term future. Based on reader correspondence, I know this surprised some people given how much lower this figure is than historical averages.

But this projection should be no surprise because, at any given time, the current yield on a bond fund is the best estimate we have for what return the fund will earn over the fund’s duration. And the yield on Vanguard’s Total Bond fund is currently sitting at just 1.64%.

In other words, for the near future, we should probably expect bond returns to be significantly below historical averages. And we should definitely expect bond returns to be below recent past returns (a large portion of those recent returns having been due to price increases as rates dropped).

The Takeaway

In short, a period of very low (or possibly even negative) inflation-adjusted returns for most bonds is very likely — almost a mathematical certainty. But, unless your bond portfolio has an unusually long average duration, a calamitous drop is still far more likely to come from the stock side of your portfolio than from the bond side of your portfolio.

Why Use I Bonds Instead of TIPS?

A reader writes in, asking:

“I don’t understand i-bonds. They supposedly protect against inflation, but isn’t that what TIPS do? What’s the point of using treasury direct’s god awful website to buy i-bonds when I can just buy a TIPS fund in my normal Vanguard account?”

It’s true that, like TIPS, I Bonds are debt instruments issued by the federal government that offer a certain after-inflation return — as opposed to most bonds (i.e., “nominal” bonds), which offer a certain before-inflation return.

But there are meaningful differences as well.

No Interest Rate Risk

TIPS work like traditional bonds in that they pay interest every 6 months and their prices fluctuate in response to changes in market interest rates (which is relevant given that, if you want to get rid of TIPS prior to maturity, you have to sell them to a willing buyer).

In contrast, I Bonds are more akin to CDs in that they don’t actually send you interest checks at any point. Instead, the value of the I Bond grows over time until it matures or you redeem it.

While all I Bonds have a 30-year maturity, you can redeem an I Bond with the Treasury at any time, as long as you have held it for at least one year. (Note: If you redeem an I Bond prior to having held it for 5 years, there is an early redemption penalty equal to the last 3 months of interest.)

In other words, even if interest rates go up dramatically, you can still cash out your I Bond without taking a big hit on the price.

Higher Yields (right now)

The yield on an I Bond is made up of two components:

  • A “fixed rate,” which is set for the life of the bond, and
  • An “inflation rate,” which changes every 6 months based on inflation over the last 6 months.

As of right now, the fixed rate on I Bonds is 0%. In other words, I Bonds purchased right now should (before taxes) precisely keep up with inflation. Normally that wouldn’t sound particularly appealing, but with the real yield on TIPS being negative on maturities almost all the way out to 20 years, a 0% inflation-adjusted yield is relatively attractive.

Tax Advantages

Like interest on other Treasury debt instruments, interest on I Bonds is exempt from state and local income taxes.

What’s different about I Bond interest is the fact that it can be tax-deferred for federal income tax purposes. That is, you have the choice of reporting the interest each year as it accrues, or reporting all of the interest earned in the year in which you redeem the bond. For some investors, this creates an opportunity for income shifting in which you purchase I Bonds while in a high tax bracket, yet pay no taxes until you redeem them once you’re retired and in a lower tax bracket.

In addition, if you meet certain requirements, the interest on I Bonds can be entirely tax-free if you use the money to pay for qualified higher education expenses.

Drawback: Limited Availability

In periods in which I Bonds have a yield equal to or greater than that of TIPS, the primary drawback of I Bonds is simply that there are some restrictions on their purchase.

First, they must be purchased directly from the Treasury — either electronically via the Treasury Direct website or by electing (on Form 8888) to have your tax refund paid to you in the form of paper I Bonds. In addition to meaning that you cannot purchase I Bonds at your favorite brokerage firm, this means you cannot buy I Bonds in an IRA.

Also, there’s an annual limit of $10,000 per Social Security number (meaning a $20,000 annual limit for married couples) for I Bonds purchased via Treasury Direct and a $5,000 annual limit for tax-refund-purchased paper I Bonds. While this limit is plenty-big for most people in the accumulation stage making purchases each year, it can be an impediment for people wanting to move a larger portion of an existing portfolio into inflation-protected assets.

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