In our last thrilling episode (Too Much Income Can Be Hazardous to Your Financial Health – Part I) we talked about the risks of holding bond (fixed income security) funds. Simply put, the current income is nice but neither the income, not the principal increase over time, absent a good fund manger. So what’s an investor to do?

 

Find a good conservative mutual fund which invests in dividend paying stocks. Why? Because dividends paid by good companies tend to increase over time. Take Bank of America, for example. (I’m using a stock rather than a mutual fund for this illustration because it avoids having to talk about purchases, sales and capital gains distributions.)  In 1997, Bank America paid a $.70 per share dividend. If you bought the stock near its high for that year, you paid $40 per share. Today, B of A pays a $2.24 dividend and its stock sells for around $50.   Notice, the dividend has increased 3x in the past ten years. The price appreciation hasn’t been nearly as exciting, but it has kept pace with inflation. 

 

There are a lot of stocks out there like Bank America, which increase their dividend every (or almost every) year. The investor who bought B of A stock in my example has an investment currently yielding 5.6% and I would expect the yield to continue increasing. You can find many mutual funds that invest in high quality, dividend growing stocks. Start by looking at Big Cap Value funds.  Many such funds have the word income or dividend in their name.

 

As I said on Monday, there are lots of good reasons to invest in bond funds, but if you have a time horizon of ten years or more, you’ll be better off investing in a high quality equity mutual fund. You’ll end up with more principal and income. 

Bonds have higher yields then stocks. Bond funds have higher yields then stock funds. This means more current income for you. Bonds and bond funds are (generally) safer then stocks and stock funds.  They fluctuate less in value. That’s good, too. So what’s wrong with this picture? Bonds are fixed income securities. Their income doesn’t grow, nor does their principal value. As a matter of fact, the real value of their principal declines over time due to inflation. 

 

Now, before you jump all over me, yes, there are inflation-adjusted Treasury securities that increase in value with inflation and floating-rate bank loan funds whose yield should increase if interest rates go up. Also, you can realize a (usually modest) gain in principal value if you buy a bond at less then its face value and hold it until maturity.

 

And, there are some managers who through astute analysis, forecasting and trading, add value and outperform a simple buy and hold strategy. However, superior relative performance becomes harder to achieve as you go up in quality, think: High yield (“junk bonds”) at one end of the scale and U.S. Treasuries at the other.  The same is true for maturities.  There’s not much a manager can do to create relative value with short term bonds. Value can be created by correctly forecasting (good luck!) interest rates and buying, or selling, long term bonds.

 

Bond funds have their place in your portfolio. It’s always wise to have a cushion for unforeseen expenses or just to be able to take advantage of an opportunity in the market or elsewhere. If you’re going to need cash at a certain time for events such as buying a house, college education, or the like, having the safety and certainty of a bond fund is a smart investment. Caveat: if you need funds at a not too distant date don’t speculate with a risky bond fund, you’ll be unpleasantly surprised with its volatility.

 

I fear that too many investors put too much money in bond funds and too soon in their investing careers. The income may be reassuring, or seductive, but the limited appreciation and the inflation purchasing power risk must be considered. There’s one more reason not to put too much capital in bond funds. Come back on Wednesday and I’ll tell you what it is.

Bill Gross, the founder of Pimco, is the godfather of savvy bond investors and, if you’re looking for a good bond fund Pimco should be on your list.  He wrote a thought provoking piece in the May 28^th issue of FORTUNE: How to Sleep Well at Night. Bill says that bonds are less volatile than stocks, provide a higher and steadier source of income, and allow you to sleep better at night. (That’s true, although I’m going to argue in coming weeks that good performing dividend paying stocks will provide a higher level of income than bonds over time, but that’s another story.)

 

Bill admits U.S. Treasuries, which are currently yielding under 5%, may be 50 basis points (.5%) overvalued. He also acknowledges that you can get just as good returns at the bank (I’d say in money market funds). 

 

Why buy bonds? International recycling of dollars will drive yields lower, says Bill. Demand will drive up the price. Wow! The more we buy overseas, the more money foreigners will invest in U.S. Treasures. We should all go out and buy Japanese and German SUVs and use them for our daily commute. Maybe buy some French wine and a new Korean made stereo system while we’re at it. The more we spend on foreign goods, the greater the demand for U.S. Treasuries. (By the way, if Treasures have lower yields that’s good for the stock market, too! Part of the stock value equation is the Treasury yield plus an imputed risk, or rate of return, so if Treasury yields decline, the required return for stocks declines and the stock market goes up.)

 

Sounds too good to be true, Bill. It seems to me that supply and demand works the other way. The more dollars foreigners hold, the higher return they’ll demand to hold even more dollars/Treasury bonds. I also worry that perhaps a government, such as China, might hold all those Treasuries over our head at some point seeking something in return. (I’m happy to be financially independent of my parents, I don’t want to become financially dependent on China.)  

 

If Bill’s right that long term Treasuries are overvalued (who am I to argue with him?) and if I’m right about how supply and demand works, you might be right to hold only short term bond funds.