Bond investment question

[bugguts83]

Hey all!

I have a question about investing in bonds. I've got some cash that I need to invest for the short-term - one or two years. Eventually it's probably going to go towards buying real estate. Currently all my cash is parked in rewards checking accounts that give 3-4% interest after fulfilling the requirements. I'm looking at bonds as an alternative.

The question is basically, is it a bad idea to invest in a bond index fund (like Vanguard's VBMFX) for short-term savings? I know that there are separate short-term bond funds, but I've noticed that bond index funds tend to have higher yields. Now, I guess that's because the "risk" is higher, since the fund also buys junk bonds. But is there really that much risk to buying a bond index fund in the short term? I looked at the past returns, and it doesn't really seem risky.

By the way, I'm not in a high enough tax bracket to justify buying tax-free bond funds.

Thanks for any advice!

[Broken Arrow]

What's your time frame?

Bond funds have principle risk, so the other question is, how important is preserving your principle?

Frankly, I think your current bank APY is pretty darn good already....

[jIM_Ohio]

Bond funds have different risk than the bonds they hold. You should not (IMO) put 2 year money in anything other than a money market fund or ultra-short bond fund. Anything else would be too risky.

A cash account will return 3-4%. This means for every 10K invested, you earn $40. This return might not be guaranteed (the $400 might be $250), but you have significant safety.

A bond fund will return between 4-7% over 10-20 year periods of time (depends on type of bonds)... some bonds might return higher, but that is not my point. If you invest $10,000 in a bond fund, a 7% return is $700 per year. Think about that.

Compare your $250 (worst case cash) with $700 (best case bond) and ask yourself... is it worth the additional risk of the bond fund not giving you back all $10,000 plus $700 to possibly have $10700 instead of $10250. Is that $450 going to make the real estate purchase that much easier?

[Goldy]

How can you lose money in a bond market?

[LuxLiving]

They generally run the other way than stock prices. Bonds up? Stocks are generally down. Bonds down? Stocks are usually up.

Bonds TYPICALLY don't have quite as large of swings up/down as do stocks and therefore are considered a more stable risk. Various bond products have varying rates of risk.

Inflation is also a factor in bond buying.

Here's a good place to learn more:
Investing In Bonds

[zetta]

How can you lose money in a bond market?

The difference is between buying a bond directly and buying a bond fund. If you buy a bond directly, you can't lose money unless the issuer defaults -- which is highly unlikely if you are buying a very high-quality bond such as a US Treasury. If you buy a bond fund, the manager of the fund is buying a lot of bonds with the pooled money. The price of a share in the fund fluctuates, and so the fund can at times be worth less than what you paid for it.

[disneysteve]

The difference is between buying a bond directly and buying a bond fund. If you buy a bond directly, you can't lose money unless the issuer defaults

This is only a partial answer. You left out one very important detail. If you hold the individual bond UNTIL MATURITY you can't lose money unless the issuer defaults. If, however, you need to sell the bond prior to maturity, you can lose money. The market value of the bond can fluctuate up or down depending on market conditions and interest rates.

[KTP]

But you can also lose money in a bank CD if you need to sell it before maturity...

[disneysteve]

But you can also lose money in a bank CD if you need to sell it before maturity...

Kind of. You wouldn't lose principal but you would forfeit some of the interest earned. Terms vary by bank. I think it is Ally bank that is currently advertising no-penalty CDs.

With bonds, you could lose principal. A $10,000 CD will be worth at least $10,000 no matter when you cash out. A $10,000 bond could be worth less than $10,000.

[LuxLiving]

So, Bugguts83, if you are worried about buying a bond that might go belly up, you need to be careful on the RATINGS.

That's where sometimes the greed factor comes in for some folks - they want the high returns and so are willing to RISK some capital by buying lower rated bonds +/or bond funds in order to get greater returns on their $$s. This is not a judgment call I'm making - it's a perfectly legit way to possibly increase your income, as long as you are FULLY AWARE that your dollars may not be totally safe.

Like any product you buy, the more you know about what you're doing and why you're doing it and understanding the ins and outs, the better. Buyer beware.