Thursday, March 18, 1999
Q. I am 47 years old, a moderately aggressive investor, and am re-allocating my $600,000 retirement portfolio along the lines of your Couch Potato Portfolio. I will put 75 percent in the Vanguard 500 Index fund. For the remainder, should I consider part or all in a "Target Maturity" fund such as American Century Benham Target Maturity 2005. Unless I am misunderstanding the prospectus (a real possibility), such funds appear to offer the best of all (bond) worlds, i.e. An almost guaranteed rate of return to maturity— if held to maturity— with the chance to sell in the interim at a profit if prices go higher.
Can you explain how target maturity funds work and when they may or may not be appropriate?
—R.S., Houston, TX
A. There are a number of fixed maturity funds, including a number of closed end funds. There is enough variety in the genre to make it dangerous to generalize. The American Century Benham Target Maturity funds are interesting because they invest in zero coupon Treasury obligations that will mature at the stated date. This fixes your return if held to maturity.
In the meantime, however, you have the price volatility of zero coupon obligations. If interest rates go down, you do very nicely. If they go up, you do very poorly. You might even lose sleep in spite of knowing there is a maturity date. Recently, for instance, their Target 2025 fund had a year-to-date total return of minus 9.5 percent while the shorter maturity Target 2005 fund had a year-to-date total return of minus 3.6 percent.
Another caveat: this fund is best held in a tax-deferred account because it generates no current income but creates a tax liability in "imputed income"— the accretion of value as the underlying securities approach maturity.
Finally, there is the issue of cost. While the American Century Benham funds are true no-load funds and operate at very low expense ratios— 0.59 percent according to the Morningstar database— you are considering investing $150,000. That implies annual expenses of $885. With that amount to invest, you could build a ladder of Treasury securities and reduce expenses to about $50 a year, even as you reduced risk.
That would be pure Couch Potato.
Q. I am 68 years old and have my entire IRA (about $750,000) dispersed among several corporate bond funds paying on the average 8.5 percent. I understand there is some risk involved but I have observed during past year that they have been rather more stable than the market as a whole. The income from these funds along with Social Security provides for all of our needs with some left over, at least for now.
Your comments please on the wisdom of this and, if not a good idea, what would you suggest? My wife and I have no other income but the children are grown and we have no debts.
—T.D., by e-mail
A. In the current market investors are getting nice yield premiums on tax-free bonds, mortgage securities, and junk bonds. Junk bonds, for instance, are yielding nearly twice as much as comparable maturity Treasury issues. That's a big premium. As a result, many advisors are telling clients that this is a good time to own some high-yield (or junk) bonds.
The operative word here, however, is "some".
With yield in short supply, investors need to take every possible avenue to increase their interest income. That means supplementing a portfolio of Treasury obligations or Bank CDs with holdings in high-yield bond funds and Ginnie Mae funds. Personally, I think a commitment of 10 percent of your portfolio would be the limit.
According to the Morningstar database, there are now some 270 high-yield bond funds. At the end of 1998 they were providing a 30-day SEC yield of 7.33 percent and a trailing 12-month yield of 9.21 percent. So your 8.5 percent yield figure is right in the ballpark.
The total return— interest payments plus change in net asset value per share— for the group was MINUS 0.62 percent for 1998. If you took income in 1998 and spent it instead of reinvesting it, this means your principal is down about 9 percent.
As I wrote early last year, it is possible to have a bull market in Treasury securities and a bear market in junk bonds at the same time. That's pretty much what happened in 1998.
My suggestion: diversify. And do it soon.