How to Choose Among Bonds, Mutual Funds, Money Markets and CD’s

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Where are the best places to invest for fixed income in 2013? The same themes and questions in 2012 still remain in 2013: Will the economy finally stabilize or will it tip back toward recession? What will inflation do? When will interest rates go up? What is the impact of the fiscal cliff ?

We’ll begin by taking a look at various strategies, then we’ll review the basic types of fixed income investments and finish by covering alternative scenarios depending upon your fixed income needs.

The best way to invest in bond funds during rising interest rates is to either focus on short-term and intermediate-term bond funds or to diversify with various types of bond funds for diversification. By using bond funds with shorter average maturities. you can minimize the negative effect of falling prices. In theory, the longer the maturity, the more prices or the mutual fund’s net asset value (NAV) will fall as interest rates rise.

In this case, investors can consider a good short-term bond fund. such as PIMCO Low Duration D (PLDDX) or an intermediate bond fund. such as Harbor Bond (HABDX). Some investors like to use Treasury Inflation Protected Securities (TIPS) to fight inflation. An example is Vanguard Inflation-Protected Securities Fund (VIPSX). However, funds investing in TIPS are still exposed to the downside risk of falling prices as interest rates rise. Therefore the time for using TIPS in mutual funds may have passed.

Long-term investors who don’t mind taking risk and who are not concerned with fixed income needs might consider a multi-sector fund, such as Loomis Sayles Bond (LSBRX) .

‘Bond Laddering’ is a fixed income investment strategy where the investor buys individual bond securities of various maturities. Similar to CD laddering a primary goal of the investor isto reduce interest rate risk and to increase liquidity. This approach is an alternative or compliment to buying bond mutual funds.

The best time to use bond laddering is when interest rates are low and are expected to rise in the near future. For example, a bond investor will not want to tie up all of their savings in one low-yielding bond for too long. If interest rates are expected to rise the bond investor will be able to purchase higher yielding bonds as each individual bond in the ‘ladder’ matures. Equal and opposite, if interest rates are high and expected to fall, a bond ladder may not be the best option for the fixed income investor. They may want to consider buying longer maturities, such as 5-year, 10-year or even 30-year bonds to lock in higher yields .

You don’t have to be an expert to do your own bond research. All of the knowledge, terminology and complexity involved with bond markets can be accessed and made simple with a handful of simple strategies and a few useful websites. There are bond analysts and credit agencies that do most of the work for you. Therefore the bond investor only needs to know where to look and how to interpret the information that already exists.

Use a Good Website for Bond Research: To avoid these common mistakes, do some of your own research on free sites, such as Yahoo Finance for Bonds and investinginbonds.com. On these sites, you can learn more about bonds and check prices before you make a purchase. You can also check out a few articles on other sites, as this Kiplinger article on how to research and buy bonds or right here on the About.com Bonds site.

If you decide to build your own portfolio of bonds, be sure you know the basics and differences with bond mutual funds.

Individual bonds are typically held by the bond investor until maturity. The investor receives interest (fixed income) for a specified period of time, such as 3 months, 1 year, 5 years, 10 years or 20 years or more. The price of the bond may fluctuate while the investor holds the bond but the investor can receive 100% of his or her initial investment (the principal) at the time of maturity. Therefore there is no loss of principal as long as the investor holds the bond until maturity (and the issuing entity does not default because of extreme circumstances, such as bankruptcy).

This is not the same as how bond mutual funds work. With bond mutual funds, the investor does indirectly participate in the interest paid by the underlying bond securities held in the mutual fund. However, mutual funds are not valued by a price but rather a net asset value (NAV) of the underlying holdings in the portfolio. If bond prices are falling, the bond fund investor can lose some of their principal investment (NAV of the fund can fall).

Therefore bond funds carry greater market risk than bonds because the bond fund investor is fully exposed to the possibility of falling prices, whereas the bond investor can hold his or her bond to maturity, receive interest and receive their full principal back at maturity, assuming the issuing entity does not default.

CD laddering is a savings strategy where a saver or investor buys Certificates of Deposit (CDs) in increments over time. Similar to dollar-cost averaging with stocks and mutual funds, an investor, for example, will buy a fixed dollar amount on a monthly or quarterly basis.

Investors and savers use CD laddering for two primary reasons: 1)they want access to cash if needed and/or 2) They expect interest rates to rise and they want to periodically buy into higher rate CDs as they continue (climb up) the ladder. Therefore, similar to bond laddering. the best time to use the CD ladder is when interest rates are low and are expected to rise in the near future. For example, a CD investor will not want to tie up all of their savings in one low-rate CD for too long. If interest rates are expected to rise the CD investor will be able to renew at higher rates as each individual CD in the ‘ladder’ matures.

A reason why investors like dividend mutual funds now is because bonds are simply not paying much these days. The yield (interest or dividends received), for example, on 10-year Treasury Bonds is almost zero. To add insult to injury, one of the most famous bond mutual fund managers in the world, Bill Gross. has said that he likes dividend-paying stocks more than bonds right now.

Whether or not dividend mutual funds are right for you depends upon your investment goals. If you are seeking income, you may benefit by adding some dividend exposure to your overall portfolio. An easy way to get exposure to dividend-paying stocks is with an Exchange Traded Fund (ETF), such as the SPDR S&P Dividend fund (SDY) or a mutual fund, such as T. Rowe Price Dividend Growth (PRDGX) .

Some investors who are willing take on extra risk are venturing into high yield (aka junk) bonds. Some of these opportunities are being found in European banks where there is much uncertainty and some risk of bankruptcy, which drives their rates to borrow much higher. But fixed income investors need to be careful with these added risks.

Due to the complexities of bond investing and the risk of market timing. most investors will do well investing in a bond fund with experienced management. This way, you can leave the navigation of this complex credit world to those who understand it — the best bond fund managers.

If your investment objective is intermediate to long-term (at least 3 years or more) and you want to gain exposure to high relative risk, you might consider a fund such as Loomis Sayles Bond (LSBRX). which has a management team with dozens of years of experience, including Dan Fuss. who has managed bond portfolios for more than 50 years. LSBRX is a multi-sector bond fund, which means it can invest in almost any type of bond, including junk bonds, foreign bonds and emerging markets bonds.

Of course, even the best bond fund managers can make mistakes. Therefore, you may want to look closer into some reasons why to use bond index funds .

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.