June 13, 2008

The search for higher yields includes finding the trade-offs

Savers and investors are scouring the markets for better-performing assets because the yields of most interest-sensitive investments—such as money market mutual funds, certificates of deposits (CDs), bonds, and bond funds—have declined in recent months.

As part of that search, they should consider their options:

1. Lower their investment costs.
2. Take on more risk.
3. Sit tight.

The first option is a good idea in any market cycle. The second one involves trade-offs. The third deserves consideration by all long-term investors.

Lower cost, higher yield

The easiest way to squeeze more from an investment is to simply lower your costs.

"Every dollar you pay in expenses cuts into net performance," says Martin Riehl, principal of Vanguard Asset Management Services™.

Of course, choosing the lower-cost strategy means knowing what your costs are.

For mutual funds, the expense ratio is a key factor. Consider a hypothetical comparison of $100,000 invested in a money market mutual fund with an industry-average expense ratio of 0.86%, versus the same investment in a low-cost fund with an expense ratio of 0.20%. Because the difference in costs over the course of a year—$860 for the average-cost fund, $200 for the low-cost fund—would be $600, you'd be paying more to get the same yield even if the performance of the two funds was the same.

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Also keep transaction costs in mind. If you use a brokerage to purchase individual investments, such as bonds, funds, or CDs, keep an eye on costs by choosing a firm that features low commissions and fees.

Higher risk, higher yield

The second alternative recalls a truism of investing: the link between risk and potential reward. "If you try to boost your yield from fixed-income assets, you should be aware of the additional risks you will face," says Mr. Riehl.

Among the risks you may encounter:

• Liquidity risk. This refers to the ease with which you can convert an asset into cash. Take, for example, bank CDs, which you can purchase through a brokerage firm or directly from an issuing bank. Although CDs typically offer relatively enticing interest rates if you hold them to maturity, you'll likely pay a penalty if you redeem a bank-bought CD early. You can't redeem a brokered CD early, but you can sell it—and face interest rate risk and likely incur a fee.
• Interest rate risk. This refers to how the value of bond funds, individual bonds, and CDs purchased through brokerages declines when interest rates rise (and vice versa). A bond, bond fund, or brokerage CD with a shorter maturity has less exposure to interest-rate risk than one with a longer maturity. (You typically would favor longer maturities if you're seeking greater yield.)
• Credit-rate risk. This refers to the possibility that a bond issuer will be unable to pay interest or repay the principal on time or at all. For example, the U.S. government won't go bankrupt, but a corporation can—and that additional credit-rate risk helps inflate yield. You can seek higher yields by favoring corporate bonds over government bonds of the same maturity.

So, if you’re intent on chasing higher yield, be aware that you’ll probably have to accept more of one of these risks.

Tradeoff: Risk vs. yield

More credit risk: Government funds -> Corporate funds

More Interest rate risk: Money Market funds -> Short-term bonds (maturity 1-5 yrs) -> Intermediary-term bonds (maturity 5-10 yrs) -> Long-term bonds (maturity 10+ yrs)

Gov. Funds: 1.65%, 2.41%, 3.71%, 4.37% (MM, short, intermediary, long-term)
Corp. Funds: 2.05%, 4.92%, 5.80%, 6.35% (MM, short, intermediary, long-term)

Sources: Lipper Inc.; Lehman Brothers.

1Average Government Money Market Fund

2 Average Money Market Fund

3 Lehman 1-5 Year U.S. Treasury Index

4 Lehman 1-5 Year U.S. Credit Index

5 Lehman 5-10 Year U.S. Treasury Index

6 Lehman 5-10 Year U.S. Credit Index

7 Lehman Long U.S. Treasury Index

8 Lehman U.S.Long Credit A or Better Index

An eye on the wrong ball?

The third option may seem counterintuitive, but it can be particularly suited to long-term investors: Sit tight.

Your long-term portfolio should be based on the types of bonds—in terms of maturity and credit quality—and allocation of assets among stocks and bonds that you would feel most comfortable with, regardless of interest rate movements.

"Before you search for higher yield," says Mr. Riehl, "don't lose sight of the fact that the interest rates shouldn't be the primary driver of your long-term investment plan if your assets are properly balanced among diversified pools of stocks and bonds, and cash reserves—that is, cash you don't plan to spend. In such a portfolio, bonds and other interest-sensitive investments serve primarily as a buffer from the volatility of stocks."

You can see an aspect of the buffer effect over the short term. As noted above, bond prices move in the opposite direction of interest rates. That is why the total return of stocks dropped –6.1% while bonds climbed 6.9% for the year ended May 31, 2008.

Notes

• Stock returns are measured by the Dow Jones Wilshire 5000 Index; bond returns are measured by the Lehman U.S. Aggregate Bond Index. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
• An investment in a money market mutual fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
• Mutual funds, like all investments, are subject to risks. Investments in bond funds are subject to interest rate, credit, and inflation risk.
• Industry-average expense ratio of money market mutual funds is for non-institutional taxable funds at year-end 2007. Source: Lipper, Inc.
• Bank deposit accounts and CDs are guaranteed (within limits) as to principal and interest by the Federal Deposit Insurance Corporation, which is an agency of the federal government.
• Vanguard Asset Management Services are provided by Vanguard National Trust Company, which is a federally chartered, limited-purpose trust company operated under the supervision of the Office of the Comptroller of the Currency.
• The hypothetical example does not represent the return on any particular investment.
• Vanguard Brokerage Services is a division of Vanguard Marketing Corporation, Member FINRA.