“Don’t Let Rising Interest Rates Swamp Your 401(k)” – good advice and tips from the WS Journal article.
Is it time for 401(k) savers to abandon bond mutual funds? Many investors hit the “sell” button on bonds in June—but if your focus is on retirement, think through your options before you follow the crowd.
The specter of rising interest rates spooked investors into pulling an estimated $60.5 billion out of bond mutual funds last month—almost a 47% jump from the $41.3 billion withdrawn in October 2008, amid the worst moments of the financial crisis—according to preliminary data from the Investment Company Institute, a mutual-fund trade group and researcher.
Yields on 10-year Treasurys jumped as high as 2.6% in June, from 1.6% in early May, thanks in part to Federal Reserve Chairman Ben Bernanke’s hints about the end of the central bank’s bond-buying program, which has pushed interest rates to record lows in recent years. (Bond prices move inversely to yields.)
Some of the biggest bond funds in the 401(k) universe took hits. Pimco’s Total Return fund (PTTAX) plunged more than 5% from May 1 through July 1 (it’s down more than 3% year to date). That fund holds a whopping $79.9 billion worth of 401(k) assets, according to December 2011 data, the most current available, from researcher BrightScope.
Another big 401(k) player, Vanguard’s Total Bond Market Index fund (VBMFX), dropped about 4% in May and June, and is down more than 2% so far this year. It’s enough to make your average 401(k) investor break out in cold sweats.
Here’s your first rule: Don’t panic. Generally, the best advice for people investing for the long haul—and your retirement could well last 30 years—is to pick a suitable asset-allocation strategy, invest in low-cost mutual funds, rebalance regularly and stick with your plan to guard against the all-too-common mistake of buying high and selling low.
Still, following that prudent strategy doesn’t mean you should ignore big-picture trends. Rates have been at extraordinary lows since the 2008 crisis. They really have nowhere to go but up, forcing bond values down.
With individual bonds, investors can hold them until their maturity date to retrieve their principal. But most 401(k) participants have access only to bond mutual funds. As investors flee for the exits, managers may be forced to sell bonds before maturity to honor those redemptions.
Yet, despite the current rate outlook, it doesn’t make sense to exit bonds entirely, experts say. One reason: While interest rates are bound to rise, no one knows when. And it could well be a year or more before the Fed makes a move.
“You’re essentially timing the bond market just like people try to time the stock market and you’ve got the same risk: You could be wrong,” says Thomas Batterman, a principal at Financial Fiduciaries in Wausau, Wis.
And don’t forget why you own bonds: They provide a ballast against stock-market gyrations. “Although one component might come under pressure, it’s the other part of the portfolio that you hope is acting as a buffer. That’s the beauty of a balanced portfolio,” says Catherine Gordon, a principal with the investment strategy group at Vanguard Group.
That said, here are steps 401(k) investors might consider as they eye the bond-market upheaval:
1. Shift to shorter-term bonds
Generally, long-dated bonds suffer the most as interest rates rise.
A good approximation of risk is that for every percentage point increase in interest rates, your bond fund’s value will drop as much as its overall duration (“duration,” roughly speaking, is the average maturity of the fund’s bond holdings).If a fund’s duration is five years and yields increase two percentage points, the value of the fund will go down by about 10%.
2. Review your target allocation
“For so many years, for so many people, the formula has been 60% equities, 40% bonds,” says Bill Harris, chief executive of Personal Capital, an online wealth-management company in Redwood City, Calif. “That’s probably not appropriate today.”
“It’s a very dangerous time to be heavily in long-term bonds,” he adds. “We don’t think you should be void of long-term bonds and we certainly don’t think you should be void of bonds, but shorter durations, lower exposure to bonds than would traditionally be the case.”
3. Diversify your bond holdings
Look to your 401(k) investment menu to see whether you can shake up your bond holdings a bit.
Some advisers suggest that investors might look to international bonds, or beyond top-quality bonds, if they’re willing to accept credit risk.
High-yield bonds “will behave a little bit more like equities than a typical bond fund, and equities are poised to way outperform bonds over the next several years,” says Jerry Miccolis, co-author of “Asset Allocation For Dummies” and chief investment officer of Brinton Eaton, part of Mariner Wealth Advisors, in Madison, N.J.
If your 401(k) doesn’t offer many bond choices and you’ve got another tax-deferred account such as an IRA, consider buying into bonds there, where you’ll have more choices.
4. Consider a stable-value fund
Stable-value funds are an alternative to bonds, assuming your 401(k) offers them. With these insurance-company instruments, you’re paid a set interest rate. “Think of them as mutual funds of CDs,” Mr. Batterman says. “They will offer you the benefit of a stable principal value and interest on that stable principal value that should not be adversely affected by rising rates.”
5. Remember your time horizon
As interest rates rise, your bond fund will be buying higher-yielding issues. That’s good news for people with a long-term outlook.
“The investor would earn a higher interest rate,” says Ms. Gordon. “While there may be some short-term pain, the math of the bond market does allow, even with higher interest rates, to offset some of those losses.”
6. Check your target-date fund
Many investors in 2008-09 were shocked that their target-date retirement fund tanked right along with the stock market.
To avoid that same shock, review your target-date fund to find out what percentage is invested in bonds, and what types of bonds. Consider switching funds if you’re not comfortable with the fund’s choices.
7. Advocate for more options
Outside of a retirement plan, investors have access to investments that aim to ply a middle road between riskier equities and bonds, such as low-volatility ETFs, absolute-return funds and the like, and individual bonds.
Those choices are not available in most 401(k) plans, but some employers offer their retirement-plan participants access to a brokerage window, which gives them access to stocks, mutual funds and ETFs via a self-directed brokerage account. Lobby your employer for this option.
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