Archives for June 2013

How Do GNMA Bonds Work?

A reader writes in, asking:

“I have the GNMA fund through Vanguard. I’m worried about keeping it because there seems to be nowhere for interest rates to go but up and the general rule is that bonds go down when rates go up. But does that hold true with GNMA bonds as well?”

What Are GNMA Bonds (GNMAs)?

GNMAs are mortgage-backed securities that are issued by the Government National Mortgage Association (a.k.a. Ginnie Mae) and guaranteed by the federal government. For those not familiar with mortgage-backed securities, Vanguard describes them this way:

“MBS are an investment in a pool of mortgage loans, which are the underlying asset and provide cash flow for the securities. MBS are commonly referred to as “pass-through” securities, as the principal and interest of the underlying mortgage loans “passes through” to the investor. All bondholders receive a monthly pro-rata distribution of principal and interest over the life of the security.”

A crucial thing to know about GNMAs (and other mortgage-backed bonds) is that they behave somewhat differently than other bonds.

When rates go up, GNMAs act, for the most part, like other bonds: Their prices go down.

It’s when rates go down that GNMAs act differently. When interest rates go down, people tend to prepay their mortgages (via refinancing). This results in (a portion of) the principal of GNMAs being repaid prior to maturity, thereby forcing the fund to reinvest its cash in new (lower-yielding) bonds.

What this means is that, relative to the price appreciation that other bond funds experience during periods of falling interest rates, the price appreciation of GNMA funds is limited. Note that this does not mean that the price of a GNMA fund will go down when rates go down. It simply means that the price will probably not go up at the rate at which the prices of other similar-duration bond funds would go up.

In other words, GNMAs have the same downside as other bonds, but their upside is limited. In exchange for this limited upside, GNMAs have higher yields than Treasury bonds of a similar duration.

Do GNMAs Have a Role in a Portfolio?

Generally speaking, when it comes to bonds, the market is quite efficient — meaning that, over the long term, most bonds earn returns that are commensurate with their level of risk. That is, it’s difficult to find anything that’s an especially good bargain compared to other bonds.

As a result, unless there is a specific goal you’re trying to achieve other than the typical goal of reducing the volatility of an otherwise-stock portfolio*, I tend not to have very strong opinions about which bonds to use. In other words, in my opinion, the most important point is simply to make sure that the portfolio’s overall risk level is appropriate for your needs (e.g., by using a lower overall allocation to stocks if you decide to use higher-risk bonds).

The risk profile of Vanguard’s GNMA fund includes:

Virtually no credit risk, because GNMAs are backed by the federal government,
A moderate amount of interest rate risk — roughly similar to that of Vanguard’s “total bond” fund — given an average duration of 5 years, and
The aforementioned prepayment risk (though as described above, this isn’t really a risk of loss, but rather risk in the sense that the fund’s upside is limited and the fund’s SEC yield isn’t necessarily a very good predictor for its future returns).

While GNMAs operate a bit differently than other bonds, I think they can be a reasonable thing to hold in a portfolio. That said, I cannot think of a single financial goal for which GNMAs would be better suited than other types of bonds.

*Examples would include minimizing inflation risk (by using TIPS) or improving tax-efficiency in a taxable brokerage account (by using muni bonds and/or Treasury bonds).

June 26, 2013

Is Your Allocation a Good Fit for Your Risk Tolerance?

Over the last few days, I’ve gotten several questions from readers about:

The loss that Vanguard’s TIPS fund has experienced so far this year, and
The losses that stocks have experienced so far this month.

For reference, as of this writing, Vanguard’s Inflation-Protected Securities Fund has incurred a year-to-date loss of 8.67%. And, according to Morningstar, Vanguard’s Total Stock Market Index Fund has incurred a loss of 4.53% over the last month, and Vanguard’s Total International Stock Index Fund has incurred a loss of 9.42% over the last month.

Intermediate-Term TIPS and Short-Term Losses

The idea of the intermediate-term TIPS fund is that, over the long term, it should roughly keep pace with inflation. The fund is not intended to protect against short-term losses. And with an average duration of 8.5 years, there’s no way to avoid experiencing several short-term losses over an extended holding period.

As a reminder, when interest rates move, a bond’s price will move (in the opposite direction) by an amount roughly equal to its duration, multiplied by the change in interest rates for similar bonds. Given the 8.5-year average duration for Vanguard’s Inflation-Protected Securities Fund, interest rates on intermediate-term TIPS barely have to move by 1% for the fund to experience the kind of loss it has experienced this year. In other words, this is no big deal.

Or, stated differently, if an 8.67% loss over a few months is a big deal for you, then perhaps this fund is not a good fit for your risk tolerance. For example, you may want to instead consider Vanguard’s new Short-Term Inflation-Protected Securities Fund, which has an average duration of just 2.5 years.

Another thing to remember is that, except in the case of a default, the price of any given bond will move toward its par value as the bond approaches maturity (because its value will, naturally, be its par value when the bond reaches maturity). So if you plan to hold a bond fund for a long enough period of time (longer than the fund’s average duration, as it turns out), an increase in rates is not a problem. In fact, it works out to your advantage, because the new bonds that the fund buys will have higher yields.

Stocks Go Down Sometimes.

With regard to the losses incurred by domestic and international stocks this month, the “this is no big deal” message is even stronger. A loss of less than 10% (and less than 5% for domestic stocks!) is the sort of thing you need to be very comfortable with if you’re going to have money in stocks.

Quite in fact, you need to be OK with the idea of a loss that is a) five-times the size that we’ve seen over the last month and b) coupled with truly terrible headlines of some sort (e.g., the U.S. going to war with somebody). Of course, you don’t have to relish the idea of a 50% market decline. But you need to know that it could happen. And you need a financial plan that won’t be ruined if it does happen.

If you’re an investor who is new to the stock market and this is your first time experiencing anything other than the superstar returns that stocks have had over the last few years, there are two reasonable ways to respond to this recent decline:

You could come to terms with the fact that this sort of thing is normal, and carry on with your plan, or
You could decide that your chosen allocation is too risky for your actual risk tolerance, scale back your stock allocation, and count it as a relatively inexpensive lesson (less expensive, that is, than waiting until a full-scale bear market to learn the lesson).

Observing how you feel in the face of real-life losses is the best way to assess your risk tolerance. If a risk tolerance questionnaire told you that you have a high risk tolerance, yet you find that you’re very worried when actual losses come along, the questionnaire was probably wrong.

June 24, 2013

Why Are Funds-of-Funds Tax-Inefficient?

A reader writes in, asking:

“You’ve mentioned in several articles that target retirement funds are not tax efficient. I don’t fully understand why they would be any worse than just holding a few index funds, since they own the same stuff in the end. Could you elaborate on this idea in an article?”

There are a few reasons why funds of funds are less tax-efficient than a DIY allocation using individual index funds.

Firstly, they result in an impaired ability to tax-loss harvest. For example, with respect to any given share purchase of a fund of funds, there will likely come a time at which one of the underlying funds is worth less than it was worth when you bought into the all-in-one-fund, yet the overall portfolio has a gain. With a fund of funds, there would be no ability to tax-loss harvest. With the individual funds, there would be such an opportunity.

In addition, even when tax-loss harvesting opportunities do come around for an investor in an all-in-one fund, it can be difficult to find another all-in-one fund that makes a good tax-loss harvesting partner. Switching to a different target date fund from the same fund company would often mean an undesired change in your asset allocation, and switching to a target date fund with a different company would likely mean a dramatic increase in costs.

Second, depending on your federal income tax rate and your state income tax rate, you might find it advantageous to use municipal bonds (which are exempt from federal income tax) or Treasury bonds (which are exempt from state income taxes) instead of the “total bond” -type of fund that is included in many all-in-one funds (including Vanguard’s Target Retirement and LifeStrategy funds).

Third, if you have tax-sheltered retirement accounts in addition to taxable brokerage accounts, you might benefit from implementing an “asset location” plan — that is, placing your least tax-efficient assets in your tax-sheltered retirement accounts prior to placing your more tax-efficient assets in such accounts — rather than holding the same asset allocation in your taxable accounts and your retirement accounts.

June 19, 2013

Brokered CDs: Are They Worth Using?

A reader writes in, asking:

“I am retired and would like to put half of the bond side of my portfolio in CDs. My total retirement IRA is now at Fidelity. I also like to take the ‘lazier approach.’ So my question: What do you think about new or secondary market CDs from Fidelity?”

CDs purchased via a brokerage firm are known as “brokered CDs.” While brokered CDs can sometimes play a useful role in a portfolio, it’s important to understand that they’re meaningfully different from CDs purchased directly at a bank or credit union.

Interest Rate Risk

A major drawback of brokered CDs relative to directly-issued bank CDs is that brokered CDs cannot be redeemed with the issuer. Instead, they must be sold on the secondary market. As a result, they will experience the same sort of interest rate risk (i.e., price volatility) that other bonds do. That is, if you need to sell your brokered CD prior to maturity and rates have increased significantly since the time at which you bought the CD, it’s likely that you’re going to take a loss on the investment (due to the price decline and the bid/ask spread).

In contrast, it’s possible to find directly-issued bank CDs that have almost no interest rate risk because they have low penalties for early withdrawal.

Call Risk

A second potential drawback is that some brokered CDs are callable, meaning the bank has the option to “call” (i.e., force redemption of) the CD at certain times, stated in the CD contract’s terms. This becomes relevant in scenarios in which rates go down after you buy your CD. In such cases, the bank will often call the CD, forcing you to reinvest the money at the new lower rates (if you want to keep the money in some sort of fixed-income investment, that is).

When Can Brokered CDs Make Sense?

Despite their drawbacks, brokered CDs do have one advantage: convenience. Buying brokered CDs is less work than moving money from bank to bank as your CDs mature, in order to get the best rates around. As a result, even though it’s unlikely that you’ll find as good of a deal on brokered CDs as you could find on directly-issued bank CDs, non-callable brokered CDs can still be worth considering if:

You’re the type of investor who places somewhat more emphasis on convenience rather than absolute maximization of portfolio results,
The yield (after subtracting any relevant costs such as commissions) on the brokered CD in question is meaningfully greater than the yield on Treasury bonds with a similar duration, and
You stay under the FDIC limit.

June 17, 2013

Variable Annuity with a 5.5% Guaranteed Growth Rate?

A reader writes in, asking:

“Several friends have purchased the Prudential Defined Income Variable Annuity. The illustration we were given shows a guaranteed 5.5% growth rate, meaning $100,000 invested for 12 years would be almost $200,000. But everything I read says to stay away from variable annuities. Have you published anything that explains why this isn’t a good deal?”

Typically, what’s going on with illustrations like the one mentioned is that the illustrated value (e.g., $200,000 after 12 years) isn’t exactly real money. That is, it’s not the same as having $200,000 in mutual funds, stocks, bonds, CDs, or cash.

Generally speaking:

If you were to cash in the annuity all at once, you wouldn’t get the full $200,000, and
If you instead choose to turn on the income stream, it would typically pay out at a rate significantly below what you could get with an ordinary fixed lifetime annuity. (That is, it doesn’t buy $200,000-worth of annuitized income either.)

A reading of the actual prospectus for the Prudential Defined Income Variable Annuity shows that this is indeed what’s going on here. In this particular case, there are two important terms to understand:

The annuity’s “account value” and
What’s referred to in the annuity’s promotional literature as the “protected withdrawal value.”

What Do You Get if You Cash It In?

The account value is the amount that you would receive if you were to cash in the annuity. (Although if you cash it in within the first 7 years, you will actually get somewhat less because a “contingent deferred sales charge” will apply.)

The account value does not grow at a guaranteed 5.5% per year. Instead, the account value grows (or fails to grow) based on the performance of the underlying “sub-account.” In the case of this annuity, the sub-account invests in a bond fund (Advanced Series Trust AST Long Duration Bond Portfolio) with a 0.83% expense ratio, to which an annual insurance cost of 1.9% is added.

Suffice to say, a bond fund facing annual costs of 2.73% is likely to grow at a rate much slower than 5.5% per year. (In fact, with rates as low as they are, I would be surprised to see any noticeable growth over the next several years from a bond fund with such high expenses.)

How Much Income Can You Get?

The amount that is growing at a guaranteed 5.5% annual rate is the “protected withdrawal value.” This is the amount upon which the lifetime income benefit is based. That is, if/when you turn on the stream of guaranteed lifetime income, the amount you’re guaranteed to receive per year is the protected withdrawal value multiplied by a rate that’s based on your age.

But, as it turns out, that age-based rate is not anything to write home about. For example, a 65-year old would receive a 5% payout (regardless of gender). In contrast, by shopping around online, a 65-year old female could get a fixed lifetime annuity paying 6%, and a 65-year old male could get an annuity paying 6.54%.**

In addition, the age-based rate is based on your age as of the date the annuity was issued (i.e., when you first bought it) as opposed to your age when you decide to begin taking income from the annuity.

Let’s look at an example.

Sue is 65 years old. She puts $100,000 into this annuity, then waits 5 years (until age 70), at which point she begins taking withdrawals per the defined income benefit. Her “protected withdrawal value” has grown at the guaranteed 5.5% annual rate, from $100,000 to $130,696. Sue’s guaranteed annual lifetime income will be calculated as her “protected withdrawal value” of $130,696, multiplied by the 5% payout ratio for somebody age 65 (i.e., her age when she purchased the annuity). Result: She’s guaranteed to receive $6,535 per year for the rest of her life.

But guess what? Given her age of 70, if she went online and searched for annuity quotes, she would find that she could get a fixed lifetime annuity paying 6.65% per year.** In other words, she could get that $6,535 of guaranteed lifetime income for just $98,271 using a fixed lifetime annuity.

In short, the enticing 5.5% guaranteed growth rate isn’t anything like a guaranteed 5.5% rate of return. The “protected withdrawal value” that’s guaranteed to grow at that 5.5% rate cannot be cashed out, and the income it provides is worth less than it appears to be worth once you actually compare it to simple fixed lifetime annuities available elsewhere.

**These annuity quotes are for fixed lifetime annuities with a 10-year period certain guarantee, because the Prudential annuity’s defined income benefit comes with such a guarantee. If you have no interest in such a guarantee, you could find higher-paying quotes for simple fixed lifetime annuities.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

See it on Amazon.

Topics Covered in the Book:

How to calculate how much you’ll need saved before you can retire,
How to minimize the risk of outliving your money,
How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Read other reviews on Amazon

June 12, 2013

Getting Crafty with Two-Fund Portfolios

After the recent article explaining that, yes, my wife and I still use Vanguard’s LifeStrategy Growth fund for our retirement savings, and, yes, we’re happy with it, a number of readers wrote in to ask about other ways to build a simple portfolio or to share their own methods of doing so.

Two-Fund Portfolios Using Total World Stock ETF

Several readers wrote in to say that they like the idea of a simple portfolio, but are not especially enamored with the Total Bond Market Index Fund that is included in Vanguard’s funds-of-funds. One reader wanted to shift toward corporate bonds in order to get the slightly higher yields. Another wanted to shift in precisely the opposite direction, using exclusively Treasury bonds. Still other readers said they wanted to stick to short-duration bonds in order to minimize interest rate risk.

Any of these desired allocations could be satisfied while still keeping things very simple by crafting a two-fund portfolio consisting of Vanguard’s Total World Stock ETF and the bond fund of your choosing. (While I don’t usually have a strong opinion on the mutual-fund-vs-ETF question, I think with Vanguard’s Total World Stock fund it makes sense to use the ETF, given that there is no Admiral Shares version of the traditional index fund.)

LifeStrategy Plus Tilt

A few readers wrote in to say that they like to keep things simple, but they also like the idea of tilting toward a specific category of stocks (either REITs or small-cap/value stocks), so they’ve created two-fund portfolios consisting of a LifeStrategy fund plus Vanguard’s Small-Cap Value Index Fund or a LifeStrategy fund combined with Vanguard’s REIT Index Fund.

Personally, I think it’s very neat that so many different diversified portfolios can be created using just two mutual funds. That said, as usual, a list of caveats applies:

Funds-of-funds (such as the LifeStrategy funds) are tax-inefficient, which is relevant if some of your assets are in taxable brokerage accounts.
Even Vanguard’s funds-of-funds have slightly higher expense ratios than the expense ratios you could have if you built a portfolio using the underlying funds.
Depending on how happy you are spending time in Excel, once you’ve moved beyond a portfolio that automatically rebalances itself, two funds might not be a heck of a lot easier than three, four, or even more funds.

June 10, 2013

Archives for June 2013

Get new articles by email:

How Do GNMA Bonds Work?

What Are GNMA Bonds (GNMAs)?

Do GNMAs Have a Role in a Portfolio?

Is Your Allocation a Good Fit for Your Risk Tolerance?

Intermediate-Term TIPS and Short-Term Losses

Stocks Go Down Sometimes.

Why Are Funds-of-Funds Tax-Inefficient?

Brokered CDs: Are They Worth Using?

Interest Rate Risk

Call Risk

When Can Brokered CDs Make Sense?

Variable Annuity with a 5.5% Guaranteed Growth Rate?

What Do You Get if You Cash It In?

How Much Income Can You Get?

Let’s look at an example.

Retiring Soon? Pick Up a Copy of My Book:

Getting Crafty with Two-Fund Portfolios

Two-Fund Portfolios Using Total World Stock ETF

LifeStrategy Plus Tilt

Welcome

Recommended Reading

My Latest Books