Interest Rates and Your Bond Funds
By Ron DeLegge, Editor
October 31, 2008

SAN DIEGO (ETFguide.com) – This week the Federal Reserve reduced the target federal funds rate at which banks lend to each other by one half-percent to 1 per cent.

What does it mean? Many investors are so busy following stocks, they forget about the impact of rate changes on their bond investments.

Lower interest rates make borrowing money easier for businesses and consumers alike. The hope is that it will stir business activity and spending to help the economy. However, lower rates also translate into lower yields for bond investors. Conversely, while bond investors have seen their yields fall, this has been offset by higher bond prices.

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Bonds are an attractive investment for people focused on generating portfolio income. Bonds can also stabilize your portfolio when other major asset classes like stocks, real estate and commodities aren’t performing well.

Bonding Your Portfolio
How can you incorporate bonds into your investment strategy?

One easy way is to buy a low cost index fund or ETF that invests in bonds.

Vanguard’s Total Bond Market ETF (NYSEArca: BND) is an excellent choice for a core bond holding. In any given year, it’ll outperform 70 percent or more of actively managed bond mutual funds plus the fund’s annual expenses are just 0.11 percent compared to an elevated 0.98 percent for the typical bond mutual fund.

Just how important are low expenses?

“If you look at the performance of bond funds in the long run, the least expensive funds typically do pay the best,” says Russell Wild, fee-only financial planner and author of Bond Investing for Dummies (2007 Wiley Publishing).

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BND has posted a 5.4 percent year-to-date decline and is also available as an index mutual fund (Nasdaq: VBMFX). Its annual yield through the end of September was around 4.7 percent.

BND’s underlying index is the broadest measure of the investment-grade taxable U.S. bond market, including most Treasury, agency, corporate, mortgage-backed, asset-backed, and international dollar-denominated issues. Other ETFs that follow the same strategy as BND are the iShares Lehman Aggregate Bond Index Fund (NYSEArca: AGG) and the SPDR Lehman Aggregate Bond Fund (AMEX: LAG).

Deflation or Inflation?
Right now the most pressing concern is the severe deflation we’ve experienced in the prices of stocks, real estate, and commodities. As the Federal Reserve and other central banks attempt to counteract this through interest rate cuts and other financial tactics, inflation may re-emerge.

Owning inflation protected Treasuries, also known as “TIPS” is one easy way to protect against the threat of inflation. Low cost ETFs that follow various TIPS indexes are the SPDR Barlcays Capital TIPS ETF (AMEX: IPE) or the iShares Lehman TIPS Bond Fund (NYSEArca: TIP). Both funds charge reasonable annual expenses just under one-quarter percent.

So far, one of the bright spots within this year’s unsettling bond market has been long-term Treasuries.

Despite global financial turmoil, the Vanguard Extended Duration Treasury ETF (NYSEArca: EDV) has gained 2.8 percent year-to-date. EDV follows an index of passively selected zero-coupon U.S. Treasury securities (Treasury STRIPS) with maturities ranging from 20 to 30 years. A Treasury STRIP is a single coupon or principal payment from a U.S. Treasury security that has been “stripped” into separately tradable components. All Treasury STRIPS within this Index are assigned an equal weighting and rebalanced quarterly.

Finding Your Own Personal Tax Haven
People in high tax brackets should look at sheltering their income in a municipal bond fund. California residents should check out the SPDR Lehman California Municipal Bond ETF (AMEX: CXA) and New York residents should look at the SPDR Lehman New York Municipal Bond ETF (AMEX: INY). Investors that don’t want exposure to a single geographic region should consider the iShares S&P National Municipal Bond ETF (AMEX: MUB).

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CXA has a current yield of around 4.7 percent and here’s what it means: A California resident in the 33 percent tax bracket would have to generate a taxable yield equal to 7.73 percent to net the same amount of income. Talk with your financial or tax planner to find out your taxable equivalent
yield or “TEY.”

Munibonds are issued by states, cities and local governments. The interest income received from munibonds is generally tax exempt from federal income tax and from the income tax of the state where they are issued.

Over the past month ETFguide.com's ETF Profit Strategy newsletter has shown its subscribers which bond ETFs look the best during these turbulent times. Investment resources like this can help you to make informed investment decisions.