Bonds Step Up to Money Market Funds

There are quite a few options to consider in lieuof money market funds, which have beenyielding miniscule returns these days. Eachoption has its risks and potential benefits,including short-term bonds and bond funds. You shouldclearly understand the risks you will be taking and thinkthrough how you will react when interest rates eventuallygo up. Since dealing with bonds is always more complexthan it looks, let's take a look at some of the considerationsin making your decision.

Ups and Downsides

Suppose you decide to buy 3-year maturity, highquality corporate bonds as substitutes for a part ofyour money market holdings and $100 of bonds atpar with a coupon of 2.75%. If you hold the bonds tomaturity, you will receive a coupon payment of about$1.375 every 6 months and the full $100 at maturity.This return is nearly 2% higher than current moneymarket fund yields.

If short-term interest rates go up in the near future,the market value of the bonds will go down. Likely,bonds' market values will decrease by about 2% forevery 1% increase in the interest rate in the nearfuture. But as long as you don't sell the bonds, youcan consider that a paper loss and will get back your$100 at maturity.

What you lose:

You won't be able to earn any higherreturns on that part of your portfolio for the next 3years. If short-term interest rates go up to 4% the dayafter you buy bonds, you will be foregoing 1.25% (4%-2.75%) of interest per year for the next 3 years, or atotal of about 3.75%.

Bottom-line Suggestions

It comes down to when short-term interest rates willgo up and by how much. If you think it will go up soonand substantially, you're better off waiting in the moneymarket funds. If you think interest rates will soonincrease substantially, you're better off moving at leastsome of your money market fund assets into short-termbonds. No one can tell for sure when and by how muchinterest rates will change, although you can find manyopinions by turning on the business news channels onyour TV for a few minutes.

Should you buy individual bonds or invest in a short-termbond fund? Go with the latter. If you aren't knowledgeableand try to buy bonds in small quantities, you'llprobably end up with poor deals.

Note:

Contrary to what you may have heard, bonds andbond funds are equivalent in terms of interest raterisk. If interest rates go up, the price of your bondfund shares will go down, and whenever you sell thefund shares, the principal you receive back normallywill be less than what you had invested. Due todifferential tax considerations, buy the bond fund in atax-advantaged account.

Remember that to earn the same return in a bondfund as you would have earned buying and holdingbonds of equivalent maturity, you need to hold the bondfund for the same length of time, accepting a paper loss.

If you have a large sum of nonemergency money sittingaround in money market funds, it may pay to movesome of it into a good short-term bond fund. Look for abond fund with an expense ratio of 0.3% or lower. Itmatters even more now because interest rates are so low.Make sure that the fund's average maturity is less than 3years and the fund's managers are not playing gameswith its holdings to goose up returns to attract investors.There are several good funds available now, includingthe Vanguard Short-term Corporate fund.

Chandan Sengupta, author of The Only ProvenRoad to Investment Success (John Wiley; 2001),currently teaches finance at the Fordham UniversityGraduate School of Business and consultswith individuals on financial planning and investmentmanagement. He welcomes questions orcomments at chandansen@aol.com.