Q. I know your views on a 5-yr treasury ladder vs. bond funds, and I agree with them if income is the sole issue. However, I have circumstances that do not fit a bond ladder; I need ongoing liquidity in a fairly sizable amount relative to my total investments.

The background to my question is this: I am retired. About 25 percent of my portfolio is invested in fixed-income, divided evenly between Vanguard GNMA fund and Vanguard short-term bond fund (index). The GNMA is in a taxable account, and it is invested indefinitely for income. I expect to need the funds, including principal, in the STBF IRA account for annual living expenses beginning in eight or ten years.

My question: I am inclined to switch the STBF IRA account to GNMA. Do you think I would have too much invested in the GNMA fund if I were to do that?

(The other 75 percent of my portfolio is in Vanguard's total stock market index fund, some taxable and some in IRAs.)

---J.P., Dallas, by e-mail


A.   There's liquidity. And there is liquidity at a price. All of us need to know the difference. One of the reasons I favor a simple ladder of Treasuries for a person who is retired is liquidity. If you own a security directly, you will receive your original investment back on the day it matures. When you establish a ladder of maturities you will have an exact schedule of maturities.

The two-year Treasury, for instance, is sold at Treasury auctions every month. This means you could buy the monthly notes in equal amounts for 24 months. This would give you a regular flow of maturing securities, all returning your original principal. If you needed more money than you could obtain by allowing notes to mature you could always borrow against them. This is liquidity without risk.

A mutual fund is different.

While you can redeem your shares at the end of any given day and have virtually immediate cash, you achieve this by accepting market risk. So it is liquidity at a cost.

  If you need money when interest rates have risen, you have substantial risk because your shares will be redeemed at the net asset value of the funds' portfolio that day.

A long maturity portfolio has more risk than a short maturity portfolio. You will always be at risk that the sales will be made at a loss rather than having individual securities mature at full value.

That said, the ease and convenience of mutual funds is hard to beat.

Portfolio maturity is one of the big differences between the Vanguard GNMA fund and the Vanguard Short-term Bond Index fund. Both are no-load, low-expense funds with 5 star ratings from Morningstar. Think of it as choosing between whether you want to be watched over by an angel with pink wings or an angel with rose wings.

GNMA, however, has an average maturity of 5.5 years compared to the 2.8 years of Short-term. So Short-term has somewhat less risk.

What to do?

Here are two solutions.

  •           Make a more careful estimate of your probable liquidity needs. Do                you think you would need more than a year of income to meet any                need? How about six months? There is a good chance you don't need                12.5 percent of your portfolio in short-term bonds. If so, you can                transfer a large portion of your Vanguard Short-term Bond fund                holding to Vanguard GNMA.

•           Do the same estimate and move money to GNMA. But put the remainder                of your Short Term Bond fund holding in a money market fund. Like                having a Treasury ladder, this will remove you from any interest                rate risk.