Shake Your Bond-bond

By Scott Lummer
Chief Investment Officer, mPower

Investors shy away from the classics

This week's question is related to a very disturbing and dangerous trend in our country -- besides the increasing amount of airplay of Ricky Martin songs.

The trend is that more and more investors are investing in money market funds.

According to the Investment Company Institute, more money has been invested in money market funds than in equity funds over the past two years, leading some analysts to comment that the money market trend shows investors are becoming more conservative.

But regardless of investor motives, this investment strategy is very ill-advised. I'm not critical because these investors are choosing money market funds over equity funds. I'm critical because they are overlooking short-term bond funds.

Why not invest in bond funds? They seem to pay about what a money market fund does.

The simple answer is, long-term investors concerned with safety and liquidity should put their money into short-term bond funds as opposed to money market funds.

Attractive short-term bonds

When most investors analyze their goals, they consider themselves long-term (over 10 years) in nature. If you are saving for long-term goals, then liquidity is not a concern.

The only thing money market funds are good for is liquidity. While they provide protection against inflation, so do other instruments, like short-term bond funds and inflation-linked bonds (my definition of a short-term bond fund is one with an average maturity of 1 to 3 years). For a long-term investor, the difference in risk between investing in money market funds and investing in these other instruments is trivial, and yet the difference in return is huge.

More bang for your buck

Typical short-term bond funds are currently yielding 6.3%, while money market funds are yielding about 5.5%. This yield difference is right in line with the typical spread between money markets and short-term bonds.

Why the big yield difference?

While most investors invest for long-term needs, there are a substantial number who may need the money over the next few years. Because these investors need liquidity, they feel they must use money market funds to safely achieve their goals. This creates a lot of demand for money market securities, which drives down the interest rate that borrowers need to pay on money market investments.

A lower interest rate means a lower yield for the investor, on both money market securities and short-term bonds. Long-term investors with less stringent liquidity needs should consider choosing short-term bond funds ¾ with their slightly higher yield.

Look at it this way. Suppose you are driving down a toll road. Being the prepared person you are, you make sure you have exact change. However, the toll authorities provide two lanes -- one for those without the exact toll who must stop for change, and an express lane for people like you, who don't need the liquidity. Typically the lane needing liquidity is much more crowded, so you are better off with the express lane (unless you have a crush on the toll booth operator).

Why doesn't everyone know this?

Because, as I commented in a column a few weeks ago, bonds are boring. Since they are boring, many well-respected advisors don't take the time to fully understand them. A well-known financial writer made an observation a few years ago that most investors who own equity funds would be better off diversifying into money markets than into bonds. I supplied him with the data he used in his comparisons -- he compared money markets with long-term bonds maturing in 20 years. If the only bonds I could buy matured in 20 years, then I would use money markets too, because of the high volatility of long-term bonds.

But short-term and inflation-linked bonds make much more sense than either long-term bonds or money markets. It's kind of like comparing opera and modern music -- but the only modern music you have to compare with Tosca is "Shake Your Bon-Bon" by Ricky Martin. However, if you also include as modern music the Eagles, Paul Simon, and Alanis Morrisette, you might come up with a different choice.

What if my 401(k) plan doesn't have short-term bonds?

Many plans don't. First of all, see if the plan has a fixed account or stable value fund. Many of these instruments have characteristics similar to short-term bonds -- such as low risk, returns that will rise with inflation, and yields much greater than money market funds.

If not, then the plan might have an intermediate-term bond fund (a fund with an average maturity of 3 to 10 years). In that case, consider diversifying between the intermediate bond fund and the money market fund. The rule of thumb? Put 3/4 of the money in the intermediate bonds.

But the main point is to avoid money market funds if you have a long-term investment horizon. Come to think of it, money market funds are a lot like Ricky Martin songs -- they are low on maturity, create little interest, and (hopefully) will expire in less than a year.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Shake Your Bond-bond

By Scott Lummer
Chief Investment Officer, mPower

Investors shy away from the classics

This week's question is related to a very disturbing and dangerous trend in our country -- besides the increasing amount of airplay of Ricky Martin songs.

The trend is that more and more investors are investing in money market funds.

According to the Investment Company Institute, more money has been invested in money market funds than in equity funds over the past two years, leading some analysts to comment that the money market trend shows investors are becoming more conservative.

But regardless of investor motives, this investment strategy is very ill-advised. I'm not critical because these investors are choosing money market funds over equity funds. I'm critical because they are overlooking short-term bond funds.

Why not invest in bond funds? They seem to pay about what a money market fund does.

The simple answer is, long-term investors concerned with safety and liquidity should put their money into short-term bond funds as opposed to money market funds.

Attractive short-term bonds

When most investors analyze their goals, they consider themselves long-term (over 10 years) in nature. If you are saving for long-term goals, then liquidity is not a concern.

The only thing money market funds are good for is liquidity. While they provide protection against inflation, so do other instruments, like short-term bond funds and inflation-linked bonds (my definition of a short-term bond fund is one with an average maturity of 1 to 3 years). For a long-term investor, the difference in risk between investing in money market funds and investing in these other instruments is trivial, and yet the difference in return is huge.

More bang for your buck

Typical short-term bond funds are currently yielding 6.3%, while money market funds are yielding about 5.5%. This yield difference is right in line with the typical spread between money markets and short-term bonds.

Why the big yield difference?

While most investors invest for long-term needs, there are a substantial number who may need the money over the next few years. Because these investors need liquidity, they feel they must use money market funds to safely achieve their goals. This creates a lot of demand for money market securities, which drives down the interest rate that borrowers need to pay on money market investments.

A lower interest rate means a lower yield for the investor, on both money market securities and short-term bonds. Long-term investors with less stringent liquidity needs should consider choosing short-term bond funds ¾ with their slightly higher yield.

Look at it this way. Suppose you are driving down a toll road. Being the prepared person you are, you make sure you have exact change. However, the toll authorities provide two lanes -- one for those without the exact toll who must stop for change, and an express lane for people like you, who don't need the liquidity. Typically the lane needing liquidity is much more crowded, so you are better off with the express lane (unless you have a crush on the toll booth operator).

Why doesn't everyone know this?

Because, as I commented in a column a few weeks ago, bonds are boring. Since they are boring, many well-respected advisors don't take the time to fully understand them. A well-known financial writer made an observation a few years ago that most investors who own equity funds would be better off diversifying into money markets than into bonds. I supplied him with the data he used in his comparisons -- he compared money markets with long-term bonds maturing in 20 years. If the only bonds I could buy matured in 20 years, then I would use money markets too, because of the high volatility of long-term bonds.

But short-term and inflation-linked bonds make much more sense than either long-term bonds or money markets. It's kind of like comparing opera and modern music -- but the only modern music you have to compare with Tosca is "Shake Your Bon-Bon" by Ricky Martin. However, if you also include as modern music the Eagles, Paul Simon, and Alanis Morrisette, you might come up with a different choice.

What if my 401(k) plan doesn't have short-term bonds?

Many plans don't. First of all, see if the plan has a fixed account or stable value fund. Many of these instruments have characteristics similar to short-term bonds -- such as low risk, returns that will rise with inflation, and yields much greater than money market funds.

If not, then the plan might have an intermediate-term bond fund (a fund with an average maturity of 3 to 10 years). In that case, consider diversifying between the intermediate bond fund and the money market fund. The rule of thumb? Put 3/4 of the money in the intermediate bonds.

But the main point is to avoid money market funds if you have a long-term investment horizon. Come to think of it, money market funds are a lot like Ricky Martin songs -- they are low on maturity, create little interest, and (hopefully) will expire in less than a year.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.