Saturday, February 26, 2005

Money Market Fund Vs. Short-Term Bond Index Fund

I am currently contemplating the risks and returns associated with investing in a money market fund and a short-term bond index fund. The vanguard funds are chosen here for comparison purposes.

The Vanguard Prime Money Market Fund is yielding 2.26% at this writing. The short-term yields are rising with the Fed rate hikes and some projections put Fed rates at 3.50% by the end of 2005. This will cause the yield of the Vanguard Prime Money Market Fund to rise to about 3.25% by the year end. On average, an investor in this fund will earn about 2.75% return for 2005.

The Vanguard Short Term Bond Index Fund is yielding 3.49% today. The projections put the yield of this fund at about 4.50% at the end of 2005. The expected “income” part of the return an investor will receive in this fund this year will be about 4%. The duration of the fund is 2.4 years. Since the yield will rise about 1% this year the price of the bonds will fall by 2.4%. That is, the “total” return an investor will receive will be 4% - 2.4% = 1.6%. This return is approximately 125 basis points lower than the expected Money Market fund return.

Relatively speaking, the Money Market Fund is the better parking place for the money as of today.

All disclaimers apply.

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