Should I Dump My Bonds?

Reader Question: I am 66 years old and my wife and I are debt free.  She is the beneficiary of a $5 million trust that is 100% invested in a number of bond funds including 20% in a high yield bond fund.  My question is, “Should I sell the bond funds and buy stocks or stock mutual funds?”

Our other investment assets include a $5 million trust where I’m the beneficiary; $2 million in an IRA with Vanguard; and about $1.7 million in a handful of low cost basis individual stocks.  We do not really need the income from her trust and I want to save my principal and keep as much money as possible for our son.  He is the beneficiary of her trust at her death as well as the balance of our estate.

Answer: Let’s begin by looking at the outlook for bonds over the next three to five years.  In investing, there are few things that are ‘absolutes’.  One is that if interest rates rise, the value of the bonds and bond funds you own will fall.  The Federal Reserve has orchestrated low interest rates since the Great Recession of 2008.  They’ve done this by pumping billions of dollars into our monetary system on a monthly basis (called quantitative easing) and by lowering the Fed Funds Rate to near zero (the rate that banks borrow from each other).  The result has been historically low interest rates.  The Federal Reserve discontinued their quantitative easing last year and they have announced that they expect to begin raising the Fed Funds Rate later this year.  This certainly suggests that bonds and bond funds will face headwinds in the months and perhaps years ahead.  It’s also important to note that bonds or bond funds that are of lower quality and/or longer maturities will likely be more volatile than shorter term, higher quality bonds.

You’ve indicated that you do not need the income, or at least most of the income, from your wife’s trust.  This means that your wife (who you indicated is the trustee) is, in a sense, the ‘steward’ or custodian for the future benefit of your son.  To the extent that you feel this is true, you should consider investing more in line for how you’d invest for him.  To me this suggests that you are considering selling a large portion of your bond funds and reinvest in stocks or stock mutual funds.  A good starting point would be a 60% to 75% allocation to stocks or stock mutual funds.

With this amount of money, I prefer individual stocks over mutual funds so I can avoid the ongoing mutual fund fees.  In particular, I like the big blue chips with a strong dividend-paying history such as Southern Company and Colgate-Palmolive.  You’ll need a minimum of twenty different stocks in order to reduce ‘single-company risks’…the risk of one company failing and losing all or most of your money (i.e. Enron).  For bonds, based on my pessimistic view, I’d stick with shorter-term higher quality bonds and bond funds.  For example, two funds we use are Vanguard Limited Term Tax Free (VMLUX) which is rated AA and has an average maturity of 3.0 years; and Vanguard Short-Term Investment Grade (VFSUX) which is rated BBB and has an average maturity of 3.1 years.  You’ll also want to pay attention to the fund expense ratios.  Your funds appear to be charging about 0.70% annually, which in this low interest rate environment seems like a rather large threshold to overcome before you start earning a return.  By contrast, the Vanguard funds I mentioned have an annual expense ratio of just 0.12% and 0.10% respectively.

Reader Question: My Father recently passed away and left his 4 children $240,000.00 split four ways. I received $60,000.00.  The money comes from his 401k retirement plan.  Is this $60,000.00 taxable to me since it was an inheritance?

Answer: There will not be an inheritance tax, but it will be taxable to you as you take it out of his 401k.  This is because he received a tax deduction for his contributions to his company retirement plan.  You will be subject to Required Minimum Distributions (RMDs) based on either your life expectancy or the life expectancy of the oldest sibling, depending on how the beneficiary designation was written.  Above the RMD, you can take out as much as you wish but remember that you’ll owe income taxes on all withdrawals.