Two Good Bond Fund Buys

11/03/2008 12:00 pm EST

Focus: FUNDS

Richard Band

Editor, Profitable Investing

Richard Band, editor of Richard Band’s Profitable Investing, says bonds have been a haven in the storm, and he recommends two of them.

In the 2008 financial hurricane, there have been few places to hide (other than cold, hard cash). It’s a sign of the epidemic fear around us that prices of even many high-grade bonds have tanked.

[That’s why] I continue to believe that corporate paper offers the best value right now. Yields are so high, relative to straight Treasuries, that you may well score a capital-gains bonanza when prices swing back to normal.

If you prefer a basket of corporate bonds for greater diversification, consider an exchange traded fund, iBoxx Investment Grade Bond Fund (NYSE: LQD). LQD attempts to mimic the entire investment-grade corporate bond market (no junk). The fund operates on a shoestring, charging only 15 cents a year per $100 under management. Current yield: 6.3%. Pay up to $90. (It closed below $88 Friday—Editor.)

Perhaps the most surprising bond bargain, though, comes courtesy of the US Treasury. Since 1997, the government has issued Treasury Inflation-Protected Securities (TIPS), bonds whose principal adjusts in step with the Consumer Price Index.

Last spring, investors were maniacally chasing inflation hedges, including TIPS. The real (inflation-adjusted) yield on some TIPS maturities fell below zero, meaning that you were lending money to the government for a guaranteed loss of your purchasing power. Dumb!

Now, suddenly, the crowd is worried about depression and deflation. TIPS prices have plunged, driving up real yields to as much as 3% recently—a good return historically for an instrument as safe as US Treasury bonds. (At 3% real, a 3% inflation rate pushes up the face value of your bonds 6% in a year.) In addition, today’s real yield is the highest since 2002, so you’re getting the best deal in six years.

The only thing I don’t particularly like about TIPS is that our favorite Uncle taxes you on both the interest and the implied appreciation of the bonds each year, even though you don’t receive your principal back until maturity. To beat this nasty little surprise, I suggest holding TIPS in a tax-sheltered retirement account if you can.

You can buy TIPS through a no-load mutual fund like Vanguard Inflation Protected Securities Fund (VIPSX)—and Vanguard will gladly let you stick your fund shares in a retirement account. Another convenience of dealing with Vanguard: You can invest odd amounts whenever you like, once you’ve satisfied the $3,000 minimum to set up an account. Vanguard collects a microscopic management fee, resulting in total operating expenses for the fund of only 20 cents a year per $100 invested.

The ease and convenience of the Vanguard fund make it the best vehicle for most investors. You won’t get rich overnight with this fund, but it will help you preserve capital when the stock market is ailing—and will protect your purchasing power when inflation rears its head.

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