The Money Mustache Community
Learning, Sharing, and Teaching => Investor Alley => Topic started by: Mississippi Mudstache on September 10, 2013, 03:09:11 PM
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I'd like to get some opinions about where you would be parking your money if you needed intermediate-term returns - I'm thinking along the lines of 3-6 years.
My retirement is well-funded with about 95% in stocks. I have a reasonable, but not excessive, emergency fund that is parked in a savings account earning 0.75%.
I want to start building a pool of savings for a down payment on a home, probably about 5 years from now (I already "own" a home, but I have no or possibly negative equity). Since the term and the amount (~$40,000+) are not insignificant, I don't want to keep it locked in a savings account/CDs/money market, getting eaten alive by inflation. Bonds don't look good, either, with interest rates having nowhere to go but up. I'm curious to know how others are handling intermediate-term savings.
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I'd like to get some opinions about where you would be parking your money if you needed intermediate-term returns - I'm thinking along the lines of 3-6 years.
My retirement is well-funded with about 95% in stocks. I have a reasonable, but not excessive, emergency fund that is parked in a savings account earning 0.75%.
I want to start building a pool of savings for a down payment on a home, probably about 5 years from now (I already "own" a home, but I have no or possibly negative equity). Since the term and the amount (~$40,000+) are not insignificant, I don't want to keep it locked in a savings account/CDs/money market, getting eaten alive by inflation. Bonds don't look good, either, with interest rates having nowhere to go but up. I'm curious to know how others are handling intermediate-term savings.
I think the Vanguard (or similar) target-date funds are worth considering for that purpose.
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I'm parking my intermediate fund money, as you call it, at Vanguard in the Wellington fund. I know the value could drop substantially but I'm flexible on my timing so it makes sense for my situation.
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I think the Vanguard (or similar) target-date funds are worth considering for that purpose.
Usually Target Date funds are more for retirement, but if you want something that is more for like, just in 5 years, they have funds called LifeStrategy funds.
I'd use this tool: https://personal.vanguard.com/us/funds/tools/recommendation. You'll get some recommendations based on time frame and everything. Even if you don't like what they give, you at least can then search for something similar.
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I'd like to get some opinions about where you would be parking your money if you needed intermediate-term returns - I'm thinking along the lines of 3-6 years.
My retirement is well-funded with about 95% in stocks. I have a reasonable, but not excessive, emergency fund that is parked in a savings account earning 0.75%.
I want to start building a pool of savings for a down payment on a home, probably about 5 years from now (I already "own" a home, but I have no or possibly negative equity). Since the term and the amount (~$40,000+) are not insignificant, I don't want to keep it locked in a savings account/CDs/money market, getting eaten alive by inflation. Bonds don't look good, either, with interest rates having nowhere to go but up. I'm curious to know how others are handling intermediate-term savings.
This is a tough one. To get higher returns you have to take on more risk. Two thoughts that I have are: 1) Lending Club; and 2) A short term, high yield bond fund like SJNK.
1) Lending Club has 3 and 5 year notes, and with a substantial sum of money such as you have you can diversify across hundreds of individual loans to minimize the risk. My guess is that you might be able to get mid-single digit annual returns on these, with comparatively little risk of losing money (though definitely still possible).
2) Junk bonds often trade more like stocks than bonds; that is, they depend more on the health of the economy and the company than national interest rates. A short term fund with duration substantially less than the time period you're looking at holding the money (SJNK is the first that I found, with a duration of 2.3 years) may work for you.
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If you want a down payment in five years you want return OF money not return ON money. Don't chase yield. It rarely ends well.
You have a know liability in a known window of time. That window is so short that the SD of any high yielding asset class will not be reduced very much. For something five years out you want a riskless asset.
5 year Treasury STRIP (zero coupon bond) yields about 1.8% right now. That is the market estimate of real return and inflation over your holding period. 5 year TIPS real yield is just about zero right now and the FRB CPI-U consensus forecast for the period is just a little under 2%. So again the market has spoken. Want more than 1.8% be prepared to lose principal.
Want something more, want a risk premium? Well then you must take risk, but if you are already 95% stocks in the rest of your portfolio why the heck would you do that? Going more equities, junk bonds or whatever else would be a behavioral error. High quality bonds with maturity equal to your holding period is the only sensible *marketable* asset for your down payment.
There are non marketable options you might consider such as I bonds and CDs with small withdrawal penalties. These likely will not end up much better than the bonds mentioned above but if you have a fear of unexpected interest rate increases or unexpected inflation they provide you a riskfree exit path and are far more sensible than chasing yield into an inappropriate asset class.
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Want something more, want a risk premium? Well then you must take risk, but if you are already 95% stocks in the rest of your portfolio why the heck would you do that? Going more equities, junk bonds or whatever else would be a behavioral error. High quality bonds with maturity equal to your holding period is the only sensible *marketable* asset for your down payment.
I agree with needing to take risk to earn a risk premium, but I disagree that anything other than "high quality bonds with maturity equal to your holding period is the only sensible *marketable* asset for your down payment." If the OP is willing to live with some risk, there are higher-risk income options that I think make sense–see my previous post.
I would agree that equities have too high a likelihood of losing money for them to be a worthwhile investment over such a short time. But short maturity income of lower quality provides a good chance for higher returns than high quality, while having only a small chance of actually losing money.
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I appreciate the thoughts. I wouldn't say exactly that I have a "known liability in a known window of time", as five o'clock shadow put it, because purchasing a house will be entirely our decision, and one that we can make when we feel the time is right. We can also control the amount of money that will be needed, by choosing to purchase a more or less expensive house, or choosing to put more or less money down (we will be shooting for more than 20%).
So I'm not completely risk-averse, and The Lending Club and junk bond funds are two options that I was considering, but I've been hearing so many complaints about the Lending Club lately, I'm starting to shy away from it. On the other hand, SJNK seems like a reasonable choice for at least a portion of my money. Current yield is 6.42%, which is 36.5% compounded over 5 years. The ETF currently trades at $40, and the lowest it has ever been is $27 at the market's nadir in 2008, or 32.5% below today's price. Anything can happen, but I would be comfortable assuming the risks with at least a portion of our money.
I have about $10,000 I can invest right now, and the remaining money will be saved over the coming years. I may start with a lump sum invested in a riskier, but hopefully more profitable, junk bond fund, while putting future savings into safer bets, like Treasuries.
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I think buying junk with this money is insane, especially in today's junk market. Instead, how about an I bond? No risk, tracks inflation and no taxes until you cash it in.
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Here's another option: bond funds with defined maturity dates. These are available in either high quality or junk from Gugggenheim Investments. This is probably safer than SJNK, since it almost completely eliminates interest rate risk. The 2016 High Yield fund (BSJG) is yielding about 4%, and the 2018 High Yield fund (BSJI) about 4.6%. The high quality BSCG (2016) yields 1.5% and the 2018 (BSCI) yields about 1.7%.
http://guggenheiminvestments.com/bulletshares
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So if you have flexibility and can then take on a bit of risk you will find most of the authors I consider sound (Bogle, Swedroe, Bernstein) would still steer you away from junk bonds and instead into a mixture of high quality bonds and equity. This would have the same expected return but a better risk profile. The problem with junk bonds, especially in this low rate environment, is the risk premium gets out of whack as everyone is reaching for yields. At the same time the distribution of risk (skew and kurtosis) is not favorable for junk bonds either. Just not a good investment given the better options in the quality bond and equity markets.
Anyway, if you in fact have some flexibility probably go with bonds or bond/equity portfolio (heavy weighting to high quality bonds in this case) in which bond maturity is at least close to the zone in which you expect to need the money. Since it sounds like you will already be moving money into this over time I think a split bond/equity allocation would be easy to do. You could buy a larger allocation of equity this time around and over time invest new money into bonds and CDs. The closer you come to wanting the money get more bond and cash like.
As to the asset in question - SJNK...
Not to put too fine a point on this, but - ARE YOU KIDDING?!?!?!?!?!
It has a YTM of 6.1% with an average maturity of only 3.5 years. That's a risk premium of 5%!!!! This a bond in name only, you are trading an equity here - and a by definition pretty crappy one with enormous downside risk if things go bad and call risk if things go good.
I don't want to be too harsh, but you seem to need saving from yourself. This is an extreme, almost ridiculous case of reaching for yield exactly when you shouldn't in exactly the wrong way. You are on a behavioral path to being very poor rather than FI...
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I think buying junk with this money is insane, especially in today's junk market. Instead, how about an I bond? No risk, tracks inflation and no taxes until you cash it in.
Agreed. SJNK has a yield to maturity of 5.90% and a yield to worst of 5.04% - this is before expenses. This is not worth default risk that comes with junk.
For the OP's timeframe I like VFICX - Vanguard Inv. Grade Intermediate Term fund. Will still have some rate risk but default risk is low.
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For the OP's timeframe I like VFICX - Vanguard Inv. Grade Intermediate Term fund. Will still have some rate risk but default risk is low.
For reference average YTM is 6.5 years with a 3% yield. This is a risk premium of only about 0.8%. In other words this fund will actually act like a bond fund, not like a (bad) equity fund. Here much of the yield is coming from the longer maturity, but still in the range of when the OP wants to take money out. He can either shorten duration into another fund as he gets closer (or CDs/savings depending on the rates). If you look at the fund it is almost all A or above bonds with a tiny bit of treasuries. A very reasonable choice for someone willing to take a little bit of sensible risk for the potential additional reward.
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I don't want to be too harsh, but you seem to need saving from yourself. This is an extreme, almost ridiculous case of reaching for yield exactly when you shouldn't in exactly the wrong way. You are on a behavioral path to being very poor rather than FI...
Haha, well, you can probably tell that my knowledge of bonds is pretty sparse. The face punches are welcomed and appreciated, but rest assured that I'm not close to placing any orders right now. I am fully aware of my ignorance, and I'm actually a pretty obsessive researcher when it comes to investments. I feel very comfortable with equities, because that is what I have studied. I've largely ignored bonds, because I'm only 29, and until very recently (within the last couple of months) I have been on the traditional retirement path. Hence, aside from a single Vanguard bond fund (I'm not even sure which one off the top of my head) that holds 5% of my 401(k), all of my long-term savings are in low-cost index funds.
All that is to say, now that I have a need for a significant sum of savings in a much sooner time frame than "sometime 20+ years from now", I've become very aware of my incompetence in investing for the intermediate term. I don't even know where to start, so I'm starting here. I'm just looking for opinions on what to consider, and you've obviously giving me something to think about. I consider this a starting point for my research.
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For the OP's timeframe I like VFICX - Vanguard Inv. Grade Intermediate Term fund. Will still have some rate risk but default risk is low.
For reference average YTM is 6.5 years with a 3% yield. This is a risk premium of only about 0.8%. In other words this fund will actually act like a bond fund, not like a (bad) equity fund. Here much of the yield is coming from the longer maturity, but still in the range of when the OP wants to take money out. He can either shorten duration into another fund as he gets closer (or CDs/savings depending on the rates). If you look at the fund it is almost all A or above bonds with a tiny bit of treasuries. A very reasonable choice for someone willing to take a little bit of sensible risk for the potential additional reward.
Personally I don't think a fund with a duration of 5.4 years is appropriate for this investment. A 1.1% interest rate increase wipes out 40% of your interest income over 5 years. 5 year interest rates have gone up almost exactly that much in the last 4 months. So, if the original poster had followed your suggestion 4 months ago, he'd now be two years in the hole.
I really think funds with a defined maturity are the best bet here. The OP can take his choice of risk, but can completely eliminate interest rate risk by holding to maturity.
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@MM - Glad you didn't take offense! I know where you are coming from, when a bit younger I ignored bonds and thought they must be boring like savings accounts. Little did I realize they are actually quite complicated and the market for them is extremely harsh. Despite what Hollywood might have portrayed with hard hitting stock traders in movies the real knowledgeable, mean and downright a-holes are the fixed income traders and marketers. People running funds know that most investors will look at yield and so they will do all sorts of shenanigans to up the yield and hide the risk they took on to do so. Remember that whole disaster a few years back was really because of the bond market - not the housing market itself. Some bonds and bond funds are safe, but others are high risk, difficult to understand speculative investments. Even the "safe" ones require that you understand the risk associated with changes in interest rates and maturity (look up "duration" to understand this relationship).
It takes a little while to wrap your head around bonds but a good high level place to start in evaluating any bond or fund is the treasury yield curve. Use that to see what a treasury bond of the same maturity is returning and if the bond you are evaluating yields significantly more then you are taking on more risk for sure. The tricky part is determining how much risk, what kind of risk it is and are you getting a good return for that risk. As the bonds become more "odd" understanding all the risks becomes challenging for average folks like us. That's another reason a better way to take on risk is to just mix a very safe bond fund with an equity fund. Most of us have a good feel for equity risk and with a little reading can understand treasuries and quality corporate bonds. With that understanding you can come up with a stock/bond allocation that you are likely to better understand the behavior of.
@beltim - I agree, I was mainly highlighting how much more appropriate VFICX is than something like SJNK. The risk taken on is not huge and is easy to understand. I'd still recommend MM stick to near riskless investments with a maturity close to his expected need - and that might include non-marketable investments (savings bonds, CDs). So Treasuries, I bonds, CDs and the like. But if you want to do a bond fund and get some higher yield then taking that risk in slightly increased duration and moving into high rated corporates is not an entirely inappropriate choice. Personally given how much equity exposure he already has I don't see any advantage to taking on even the relatively small duration and credit risk in VFICX for what is a pretty small premium over a relatively short holding period.
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Thanks for the explanation, fiveoclock. I'm not one to be thin-skinned about people who are giving me advice. I would rather someone speak up if it looks like I'm about to do something stupid, rather than sit back and shake their head at my naivety. You are correct about the general impression of bonds - they have always seemed like something that old people should be interested in when they're preparing for retirement. Even the term "fixed income" seems to intertwine bonds with geriatrics.
Obviously, the reality is far from that, and it's clear that I have a lot to learn. I've looked up some of the foreign terms that have been brought up so far (yield to worst, duration, risk premium) which has led me to a lot of interesting articles. Further study is in order. Are there any authors you would recommend for a more in-depth understanding, a la Jack Bogle or Ben Graham on equities?
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I think the two best books on bonds for DIY investors like Mustachians I think are:
The Bond Book by Annette Thau
The Only Guide to a Winning Bond Strategy by Larry Swedroe
I haven't read Swedroe's book myself yet, but his writing in general is excellent and his chapters on bonds in his other books are very good as well. I have read Thau's book and for a long time I think it has been considered "the reference" for retail investors in bonds. The nice thing about Thau's book is the most recent edition (3rd) is written post crisis and so it specifically addresses issues of bond risk that most authors never bothered mentioning before. It also very methodically goes through all bond types and bond funds, accessible with good examples.
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Thanks, I will drop by the library this week to see if I can pick up either of those.
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I think the two best books on bonds for DIY investors like Mustachians I think are:
The Bond Book by Annette Thau
The Only Guide to a Winning Bond Strategy by Larry Swedroe
I haven't read Swedroe's book myself yet, but his writing in general is excellent and his chapters on bonds in his other books are very good as well. I have read Thau's book and for a long time I think it has been considered "the reference" for retail investors in bonds. The nice thing about Thau's book is the most recent edition (3rd) is written post crisis and so it specifically addresses issues of bond risk that most authors never bothered mentioning before. It also very methodically goes through all bond types and bond funds, accessible with good examples.
Thank you fiveoclockshadow!
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I'm curious what other people think about this idea:
Assuming your plan is to sell your current home and buy a new home, how about putting your savings into paying down the current mortgage? It would be roughly equivalent to investing at your mortgage's interest rate (slightly lower, due to lower mortgage interest deduction), since you will get that equity back when you sell and are ready to buy your new home. Depending on your mortgage's interest rate and tax bracket, this could be a viable option.
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Option 1: 3% bond yield reduced by 20% income tax leaves 2.4% net return (with a risk). Option 2: A cash flow of $40,000 could move the amortization schedule quite a bit. This return is tax free, risk is probably lower, and money is available at closing. Door #2 might be the answer.
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That's a good suggestion, depends on the post tax mortgage rate. When evaluating be very careful to calculate post tax rates properly - easy to get this wrong. Common errors are double counting mortgage interest deduction (i.e. adjusting mortgage interest for the tax deduction but not applying taxes to the alternative investment interest) or counting the deduction when it doesn't actually exist in whole or part (i.e. forgetting to compare to the standard deduction).
The trade off here is liquidity - you don't have it anymore when you put the $40k into the mortgage. At first it appears you will get liquidity right when you need it - when you are going to purchase the new house. However, that assumes the first house has sold before you purchase the next one and that isn't always the case. If you do need to own two houses briefly you'd much rather have that cash liquid so you can avoid or reduce expensive short term loans. So you have lost some flexibility by putting the money into the mortgage. But if the return is good enough that may be the right thing to do.