Q: I believe I understand the effect of interest rates on bonds. But two questions come to mind.
First, if you own individual bonds would you be better off keeping the bonds to maturity and getting the maturity value of the bonds, but losing out on higher rates; or should you sell and reinvest at some point in higher-interest-rate bonds?
Second, does this change with bond mutual funds — do fund managers hold bonds to maturity, or do they generally sell and reinvest when interest rates are going up?
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A: On highly liquid and secure securities such as Treasurys, the market adjusts the price of the bonds so that the discounted present value of an older, lower-coupon obligation would be identical to the discounted present value of a new bond with a higher coupon.
Some of the damage done to lower-coupon bonds in a rising-rate market is reduced by reinvestment of the coupons at the new higher rates. You can learn the basics of all of this in the classic “Inside the Yield Book” by Sidney Homer and Martin L. Liebowitz, first published in 1972.
Fund managers vary: There is no standard practice.
Q: What is a CD ladder and how does it work?
A: A CD ladder is a series of certificates of deposit with different maturities.
They are purchased so that certificates mature at regular intervals, providing principal cash for spending or reinvestment.
Ladders are not limited to CDs. You can also build them with Treasury obligations or other fixed-income securities.
A ladder can be built to almost any length. A very simple ladder would start with obligations that mature in one and two years.
At the end of the first year, the maturing security is replaced with a new two-year security.
The U.S. Treasury sells notes that mature in two, three, five, seven and 10 years, so it is possible, with some aftermarket purchases, to build ladders as long as 10 years pretty easily.
Each year one security would mature. It would be replaced with the longest maturity in your ladder.
Q: In the event of a U.S. economic crash, how safe is the Fidelity Cash Reserves Fund (Ticker: FDRXX) that is used as a core fund in Fidelity brokerage accounts?
A: Fidelity Cash Reserves Fund is quite safe by most standards, including Fido’s long history in money-market funds.
But those concerned with a major liquidity crisis should use a money-market fund that restricts itself to 100 percent government securities.
One indication that you are not alone in your concern is that on May 1, Fidelity changed the name of the Fidelity U.S. Treasury Money Market Fund (ticker: FDLXX) to Fidelity Treasury Only Money Market Fund (italics added). This fund has a minimum investment of $25,000.
Another fund, Fidelity U.S. Government Reserves (ticker: FGRXX), holds agency securities and repurchase agreements with a minimum investment of $2,500.
Copyright, 2013, Universal Press Syndicate