Am I using your monthly income bond fund recommendations correctly?

I am retired and have my IRA invested with a conservative 40% equity allocation in the Vanguard equity funds you recommend. For the fixed-income part of my portfolio, I’m using the four funds you suggest for monthly income. This is because I plan to take out the income next year, and I want to build up that part of my portfolio with higher-yielding funds. Am I making a mistake doing this?

Unless you have an above-average ability and willingness to accept price volatility in your portfolio, I think you could be making a mistake. Your overall allocation and the wording of your question suggest that you see yourself as cautious. So it is important to understand that these two bond allocations are quite different.

In general, we build our portfolios to take risks on the equity side, where we believe risk is more likely to be rewarded, and avoid as much credit risk as possible on the fixed-income side. Accordingly, the fixed-income part of our Vanguard Tax-Deferred Portfolio is made up exclusively of U.S. Treasury and agency securities in order to stabilize the overall portfolio and mitigate the effect of falling equity prices.

On the other hand, our Vanguard Monthly-Income Portfolio is aimed at investors who seek higher yield and who can afford to accept substantially higher risk. Our Web site describes this portfolio is one designed for investors who want to generate income without withdrawing principal.

In order to generate higher income, 75% of this portfolio – and apparently 45% of your total portfolio – is made up of corporate bond funds.

The monthly income portfolio has nearly twice the expected current yield of the fixed-income part of the tax-deferred portfolio. However, the credit quality of securities in the monthly-income portfolio is significantly lower than those in the tax-deferred portfolio. This raises the risk that the value of this portfolio could decline at a time when stock prices were plunging.

In 2008, when equities suffered significant losses, having the fixed-income part of your portfolio in government bonds almost certainly would have helped you stay the course. I doubt that you would have been comfortable with the majority of your bond portfolio invested in funds with higher levels of risk.

I would recommend you reexamine your needs and the level of risk you are willing to take to accomplish them.