Last Updated Jun 3, 2010 11:33 AM EDT
Yields are very low today, at least in nominal terms. Some of the largest money market accounts are yielding less than 0.10 percent APY, and even the Vanguard Total Bond Market Index Fund (VBMFX) is yielding a paltry 3.05% APY. Faced with those crumbs for returns, it's only natural to want more income.
Not too long ago
To illustrate the perils of seeking higher income, we need only stroll down memory lane a few years back to find but two of the many examples.
In mid 2007, the Schwab YieldPlus Bond Fund (SWYSX) was being heralded as a safe alternative to a money market fund. Claiming extra yield without risk made it pretty hard to resist. And I bet more investors wished they had resisted, considering it lost about half of its value over the next two years.
Going into 2008, the Oppenheimer Core Bond Fund (OPIGX) seemed like a pretty secure bet, and since it sported a little extra yield over the Vanguard Total Bond Fund, why not go for a little more? Well, in this instance, going for "more" meant you were left holding the bond bag that lost 40 percent of its value.
These two bond funds had four things in common: higher yields, high risk investments, the lure of extra income, and now as defendants in class action law suits.
Lessons from not too long ago
As short as investor memories have historically been, they seem to be getting even shorter. In the 2008 stock market crash, just when we needed our bonds to act as a shock absorber, the average bond mutual fund lost eight percent of its value, while high quality bonds earned five percent or more. Yet only two years later, it's dÃ©jÃ vu all over again.
The reality is that, in real terms, interest rates aren't so bad right now. After taxes and inflation, we are getting about seven percentage points more today than in 1980 when that CD was paying 12 percent.
I'm not recommending settling for money markets paying 0.07 percent annually. I make sure my cash is working hard in an FDIC insured bank or NCUA insured credit union. Alliant Credit Union has checking and savings accounts earning 1.50 percent APY.
What I am advising is to not repeat the mistakes of only two years ago. Don't buy the risky bond funds that are being pitched as safe and secure. Nor should you buy long-term bonds or bond funds because, if high inflation becomes a reality, your bonds will get creamed.
Never forget that the role of your fixed income portfolio is to act as your portfolio's shock absorber, not its shock creator.