Earn What You Spend

Earlier this year I went shopping for a bond fund to invest in.  I didn’t want to invest in equities because I thought I might need the money in the next year, so I figured a safe, conservative bond fund would be the best way to protect the principle.  

Looks like I wasn’t alone in this assumption.  And it looks like we were all wrong. 

Jeff Sommer writes about the investors who thought they were buying a solid, stable fund, but have still lost money in the credit crisis.  It’s painful to lose money when one has anticipated the risk; it’s even more so when you previously assumed your principle was safe: 

Many middle-of-the-road bond mutual funds that seemed to promise stable returns in a difficult market have recently taken gut-wrenching plunges. These funds, as well as managed accounts run under the same principles, have turned out to be much more volatile and risk-laden than investors generally understood.

Jeff quotes one investor who says that we made need to “rethink … the paradigm that we’ve operated under all these years, that core bond funds, focused on investment-grade bonds, are a good diversifier for a portfolio.” 

These intermediate bond funds contain “investment-grade securities” and “were often viewed as core holdings for people seeking to buffer their portfolios.”   That is, for a diversified portfolio, you should invest some of your money in risky assets such as stock, and some in more stable assets, such as investment-grade bonds.

Let’s look at what I invested in: the Vanguard Intermediate-Term Investment-Grade Fund Investor Shares (VFICX).  I distinctly remember reading the phrase “investment-grade” and equating that to principle protection.  This bond fund seemed to have a number of great things going for it: a low expense ratio (0.21%), investments in “high-quality (investment grade) corporate bonds”, and a solid historical performance.  Vanguard has this great system of graphically outlining the risk / maturity of a bond fund: 

Again, investment grade, medium term.  This all looked great to me.  So how did the fund do? 

Down 10.5% this year.  What happened here? 

First, “investment grade” does not equal “principle protection”.  This may sound obvious to many bond traders and others in the credit markets, but the common perception is that bonds provide stability while stocks give you the risk and potential for growth.  This year, at least, this just isn’t true.  Everything was risky.  

Second, I failed to adequately understand what I was investing in.  I knew about the problems in the real estate world, but had assumed I wasn’t invested in them.  Wrong: this fund invested in both commercial mortgage-backed securities as well as bonds from financial institutions heavily leveraged in real estate.  I just didn’t do my due diligence into what I was investing in.

Lastly, it’s important to understand that bonds still have risk.  Again, this is obvious to many, but the common perception is that they are much safer than stocks.  But now I get it: why would investors be willing to pay the Treasury to hold onto their money?  The Treasury rate turned negative precisely because investors feel like they have nowhere else to turn for principle protection; that is, if you don’t want to lose your money, the feeling was that you were better of paying the government to hold it than risk putting it anywhere else.

Despite the anxiety caused by losing money - especially when it was assumed to be safe - this has been quite an instructive experience.  It is important to be an educated investor, no matter what you invest in.  There is a risk to everything.  The critical thing is to understand what that risk is.