VBIIX For Higher Return

Reader Question

Hi LTR, I have cash in a savings account representing about 6 months of expenses. The money is in the AMEX online savings account with 0.9% APR. That's fine but I want to take some of that money out and invest it in a low risk fund that could provide a better return. I was thinking of the Vanguard Interm-Term Bond Index Inv/VBIIX. Is this a good idea? Are bond funds worth getting into right now? Thanks for any suggestions

My Reply

If this is an emergency fund, then you should absolutely not invest it in bonds. Today's bonds are no bargains and while they won't have a giant 50% bear market like stocks can (and did, and eventually will again), it's quite possible for them to lose 5-10% in rapid fashion -- not something you want to happen to an emergency fund.

Even if this is not an emergency fund, there is not much reason to invest 0.9%-earning cash into VBIIX which can be expected to return around 1.7% annually over the next 7 years, with that 5-10% downside risk (and possibly worse in a truly adverse scenario) -- and all that is before taxes.

Instead of VBIIX, you should consider:

• I Series US Savings Bonds. These are easily the best bond investments available today because of their absolute safety from default (being US Treasury bonds), absolute safety from interest rate risk (guaranteed to never decrease in value), near-emergency fund liquidity after one year (can be redeemed with only a small penalty after one year and no penalty after five), friendly tax treatment (taxes deferred till redemption), and very competitive yield in today's low-interest world (matching inflation exactly, which can be expected to average around 2% over the next 7 years). You can buy $10,000 of I-Bonds per calendar year per Social Security number and they should be right at the top of everyone's list of fixed-income investments. Almost everyone should be maxing these out before investing in other fixed income investments.
• CDs with option to break early at a small penalty, such as available from PenFed. The option to break reduces your interest rate risk to a minimum (2% or less) compared to 5-10+% with VBIIX. And, as you can see from the link, the yields can exceed 1.7% you can expect from VBIIX with better safety from default.
• Municipal bond mutual bonds such as VWLUX or VWALX from Vanguard. These have similar maturities to VBIIX but significantly higher yield, while being exempt from federal income taxes. They are of slightly lower credit quality than VBIIX, but are still quite highly rated (especially VWLUX) and in my estimation their higher tax-exempt yield more than makes up for the difference.

Again, if this is an emergency fund, then it should stay in cash. But if this is long-term investment money, then any of the above three options are in my opinion easily better than VBIIX. Of these three I would go with I-Bonds if you are not already investing in them (and especially if this money straddles both emergency fund and long-term investment -- I-Bonds double as an emergency fund after a year).