Bond funds are one way to avoid stress of debt

Hold them 3 to 5 years, do monthly investments

Dollars & Sense

January 05, 2003|By Russel Kinnel | Russel Kinnel,MORNINGSTAR.COM

How would you have reacted if your spouse had surprised you with a new car for the holidays? Initially, you'd probably have been thrilled, but your next thought might have been, "Uh oh, how much debt are we in?"

Besides being creepy, those holiday commercials that suggest you need to buy your spouse's love by spending a huge sum of money on a car or a diamond are peddling a bad idea from a financial-planning perspective. When the economy is slow, you should boost your savings - not your spending. So why not start investing so you can buy your next car without going into debt?

For example, if you invest $3,000 in a low-cost bond fund yielding better than 4 percent and sign up for automatic monthly investments of $400, you'd be on your way before you knew it. In three years, you'd have more than $18,000, and in four years, you'd have $24,000. I'm assuming rates stay flat, and I haven't included the tax bite, which might be about $1,000 if you're in the top bracket. If interest rates rise, they would initially depress the value of your investment, but the higher yields would compensate you for that loss fairly quickly if you were investing a sizable sum monthly and weren't in a long-term fund.

So, if you want to spare your spouse the stress of getting deeper in debt, here are a few ideas of bond funds to hold three to five years:

Vanguard Total Bond Market Index (VBMFX): This fund's diversification into a wide range of bonds makes for a pretty smooth ride. On top of that, it charges just 0.22 percent, so nearly all the portfolio's yield flows to you. (With interest rates as low as they are, some high-cost bond funds end up soaking up half their yield in expenses.) A spike in rates might leave you in the red for a year, as happened in 1994 and 1999, but it ought to work out fine for longer time periods.

Dodge & Cox Income (DODIX): Again, you get a smooth ride and low costs here. The expense ratio is quite low at 0.45 percent, yet you're getting very skilled management. This fund runs similar rate risks to Vanguard Total Bond and in fact suffered similar losses in 1994 and 1999. Still, this is a great sleep-at-night type of fund that has consistently followed a conservative strategy.

T. Rowe Price Spectrum Income (RPSIX): If your time horizon is a little longer, you might want to consider this fund. In addition to high-quality U.S. government and corporate bonds, it throws in exposure to junk bonds and foreign bonds by investing directly in Price funds dedicated to those areas.

It's definitely a step up in risk, but diversification and . Price's conservatism have kept things from getting out of hand.

It suffered its only calendar-year loss in 1994, when it shed 1.94 percent - which is less than the two aforementioned funds lost that year. Officially, its expense ratio is zero percent, because the SEC doesn't count the underlying costs of the funds in a fund-of-funds portfolio. In reality, you'll be paying about 0.6 percent in expenses.

Fidelity Spartan Intermediate Muni Income (FLTMX): If you're near the top tax bracket, a muni fund might be a better deal. Fidelity has one of the best municipal-bond groups, and it shows. This fund steadily outperforms its peers every year without taking on any scary risks. Its three-year and five-year returns top those of our other picks in the category. The expense ratio is 0.46 percent.

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