Don't Be Fooled by Money-Market Yields

As money-market yields approach 5%, investors are pouring billions of dollars into ultra-low-risk money-market funds each month. I think these investors will turn out to be wrong. The better bet just now is intermediate-term bond funds, particularly those that invest in tax-exempt municipal bonds.

The markets can often be perverse. A year ago, when intermediate-term bond funds were yielding roughly 4.5% and money-market funds were yielding around 3%, the wise move seemed obvious: Take the higher yield.

But that turned out to be a mistake. When rates move higher, bond prices fall. So Vanguard Intermediate-Term Bond Index returned just 0.1% over the past 12 months. Meanwhile, Vanguard Prime Money Market returned 4.2%.

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I think the same thing is happening in reverse today. A year ago, the Federal Reserve was hip deep in its interest-rate-tightening campaign. Today, the Fed has "paused" and seems at or near the end of the rate-hiking regimen.

The economy is slowing. Economists and investors are hoping for a "soft landing" rather than a recession -- and they'll probably be right.

Bottom line: Short and intermediate-term interest rates are likely either to stay flat or decline in the next year. And that means it's time to buy longer-term bonds, not money markets. Even for your low-risk money, a limited-term or intermediate-term muni fund is probably your best choice.

You don't have to take my word for it. Some of the nation's top bond fund managers think we've reached a peak in both short-term and long-term interest rates. They include Bill Gross, who runs Pimco Total Return and Harbor Bond fund, and Dan Fuss of Loomis Sayles Bond. These two men don't normally run with the pack. Their long-term records at the unbelievably tricky business of predicting interest rates are among the best of anyone in the business.

Which funds should you choose?

For your most conservative money, consider a short-term bond fund. Most investors will do much better after taxes in a tax-exempt fund -- unless, of course, you're investing in a tax-deferred account.

Fidelity has given Vanguard a real run for its money among bond funds in recent years, even though it charges slightly higher expenses. By not making big bets on the direction of interest rates but instead concentrating on picking undervalued bond sectors and bonds, Fidelity's performance has been slightly better in recent years than Vanguard's. Vanguard's lower expense ratios, however, are nothing to sneeze at, though, particularly on shorter-term funds.

Fidelity Short-Intermediate Muni Income (symbol FSTFX) yields 3.39%. Expenses are 0.49% annually. If interest rates rose by one percentage point, this fund would probably lose less than 3% of its value. Meantime, you'd still be earning the yield. Vanguard Limited-Term (VMLTX), yielding 3.63%, is just as good, if not better. It would drop less than 2.5% if rates jumped one percentage point. Expenses are just 0.16% annually.

Want something even safer? Take a look at Vanguard Short-Term Tax Exempt (VWSTX), yielding 3.46%. Expenses are 0.16%. It could be expected to lose just 1% if interest rates rose one percentage point.

The bulk of your bond money belongs in a good intermediate-term muni fund. True, you won't earn the yields that you get on the longer-term funds. But you also won't get the big swings in price. And to my way of thinking, bond money is mostly safe money -- a nest egg for emergencies, money you'll need in a couple of years, and ballast for the rest of your investments.

Again the top choices are Fidelity and Vanguard. Fidelity Intermediate Municipal Income (FLTMX) yields 3.75% and has an expense ratio of 0.43%. A one-percentage-point increase in interest rates would knock 5% off its price. Vanguard Intermediate-Term Tax Exempt (VWITX) yields 3.92% and charges just 0.16%. It has the same sensitivity to interest rates as the Fidelity fund.

Finally, if you live in a relatively high tax state -- say one with a tax rate in excess of 7% -- you should consider a single-state muni fund, which typically delivers income that is exempt from both state and federal taxes. Again, Fidelity and Vanguard offer good funds. Be careful, though: A lot of single-state funds offered by other families are too expensive. And I wouldn't buy a long-term single-state fund simply because a low-cost, single-state intermediate-term fund isn't available. Long-term bond funds don't generate enough extra income to compensate for the additional risk of extending maturities.

Steve has been writing for Kiplinger's for more than 25 years. As an associate editor and then senior associate editor, he covered mutual funds for Kiplinger's Personal Finance magazine from 1994-2006. He also authored a book, But Which Mutual Funds? In 2006 he joined with Jerry Tweddell, one of his best sources on investing, to form Tweddell Goldberg Investment Management to manage money for individual investors. Steve continues to write a regular column for Kiplinger.com and enjoys hearing investing questions from readers. You can contact Steve at 301.650.6567 or sgoldberg@kiplinger.com.