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Bond Funds Instead of Bank Accounts?

As long as interest rates stay low, you can earn more in a fund without taking much risk.

OUR READER

Who: Erik Fowler, 41Where: Houston

Question: Should I keep my emergency cash in a bond fund after the Standard & Poor's downgrade of U.S. debt?

SEE ALSO: Investing After the Downgrade

Since Erik put $50,000 into TCW Core Fixed Income Fund (symbol TGFNX) several years ago, he’s had no complaints. The low-risk bond fund returned 11% annualized for the past three years, beating Barclays U.S. Aggregate bond index by 3.5 percentage points. The fund pays dividends every month and yields 2.7%. “The nice thing about the fund is that it seeks good returns but favors an income approach,” Erik says.

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But when Standard & Poor’s cut the U.S. government’s credit rating from a pristine AAA to AA+ in August, Erik began to question whether this investment would continue to be dependable. “I was worried that people with a knee-jerk perspective would see the downgrade as an excuse to sell out of bond funds,” he says. “If people were getting out of the bond market, I could lose money.”

Erik can’t afford that. He’s a self-employed real estate broker, and $50,000 represents a year’s worth of living expenses—his rainy-day cushion. He treats TCW Core as a sort of souped-up bank account, a liquid investment with a return that keeps up with or beats inflation without big swings in value. Erik keeps little in the bank and dips into the fund when he needs fast cash. He also siphons off some of TCW Core’s earnings into his retirement stock funds.

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Multitasking. Erik is asking one fund to do many jobs, but he’s chosen his workhorse well. With a combination of government-backed mortgage securities and medium-term U.S. and corporate bonds, TCW Core is well suited for his needs; it offers an attractive yield, low risk, and no crazy strategies or gadgets he can’t understand. The managers are highly experienced. So is there anything he ought to worry about?

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For now, no. The bond market hasn’t suffered from the S&P rating shocker, mainly because economic weakness keeps interest rates low, and that protects or increases the value of the fund’s bonds. But investors in any fund need to keep an eye out for future risks and devise an alternative plan. Here, “the enemy of that account is rising interest rates,” says Jeff Duncan, of Duncan Financial Management, in St. Louis. “In that environment, you’re probably going to have to pull back and go to the local bank or money market account.” It’s hard to see today, but at some point money market funds and certificates of deposit will return more than a bunch of bonds.

Duncan recommends that Erik watch the ten-year Treasury yield, now below 2%. Should it start climbing, Duncan says, Erik would be wise to reduce his stake in his bond fund. One plan, says Duncan, would be to extract half of the $50,000 and put it in the bank or a money fund when ten-year Treasuries reach 3% and to move the rest if the Treasury yield gets to 3.5%. That won’t happen soon, but no recession or near-recession lasts forever. “The downgrade has nothing to do with whether Erik should own TCW,” says Drew Tignanelli, president of the Financial Consulate, in Hunt Valley, Md. “There’s no doubt that right now he’s in a good place. But he’s got to follow the total economic picture on this.”

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