Last Updated Feb 12, 2010 9:13 AM EST
Fixed income investments should be limited to Treasuries/government agencies, government-insured CDs and AAA/AA-rated municipal bonds. If you want to take a bit more risk with fixed income in an attempt to increase returns, you should limit credit risk to the short term (three years or less). The evidence shows that's the only place it has been well rewarded. And you should avoid bonds that have "optionality" in them, which means the maturity is not certain.
Two of the common alternatives for seeking higher yields are GNMAs and high-yield bonds. The Only Guide to a Winning Bond Strategy You'll Ever Need goes into detail as to why I don't recommend either. Briefly, there are two main reasons.
- First, the evidence suggests that while yields are higher than on safer investments, investors haven't been well rewarded for taking those risks.
- Second, their risks don't mix well with the risks of the other portfolio assets.
From inception (6/27/80) through 2009, the Vanguard GNMA Fund had an annualized return of 8.34 percent per year. The following are the returns of two indices that might be considered reasonable benchmarks. (The returns are the annualized returns for the time period July 1980 through December 2009.)
- Gov't Bond Index (1-30 Years) -- 8.40 percent
- Five-Year Treasury Notes -- 8.53 percent
We now turn to high-yield bonds. From inception (12/27/78) through 2009, the Vanguard High Yield Corporate Fund returned 8.72 percent per year. The following are the returns of two benchmarks. (The returns are the annualized returns for the time period 1979 through 2009.)
- Gov't Bond Index (1-30 Years) -- 8.45 percent
- Barclays Capital Credit Bond Index Intermediate -- 8.70 percent
There are two lessons you should take from the above. The first is that you shouldn't confuse yield and return. The second is that you don't need to stray beyond the safest and simplest fixed income investments to achieve your goals. In fact, the evidence suggests you shouldn't.
However, you shouldn't look at investments isolation. On Wednesday, we'll look at how the addition of GNMAs can affect portfolios.