Finance

Bond Funds in Your 401(k)

Planning for retirement

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Much has been written about an impending bear market in bonds. Interest rates are expected to rise in the future and that could mean a decline in the value of your bond holdings and added risk to your portfolio. Forewarned is forearmed. Right? Well, not always. What if you are a participant in a 401(k) with limited fixed income offerings: how easy will it be to get out of the way of this storm?

Most 401(k)s have sufficient equity fund options. But when it comes to fixed income, many plans are lacking in choices. It is not unusual to see a plan provide only one stable value fund and one intermediate term bond fund. Other plans might add a short term government bond fund or a high yield option. However, effectively handling a long term bear bond market could require more than a handful of offerings.

Not all bonds or bond funds are created equal. Various sectors of the bond market can react differently to increases in interest rates. However, in general as interest rates rise, bond values fall. In addition, characteristics of bonds, including duration and credit quality can also affect performance. When interest rates do increase, government bonds could be the sector most at risk, yet this sector is deemed by many investors to be the safest.

So what can you do about your 401(k)? The first recommendation is to talk to your human resources department. Ask for more fixed income options. Suggest the addition of a ‘strategic income’ or ‘unconstrained’ bond fund, where the bond manager has the ability to move between fixed income sectors and make adjustments designed to mitigate the downside of rising interest rates. A range of short term and international bond funds could also be helpful, along with sector specific options such as floating rate or high yield. A goal for conservative investors is to have a place to camp out during the bond bear without incurring too much volatility.

Here are five suggestions if you can’t change your 401(k). 

1. Sign up for a brokerage linked (self-directed) option on your 401(k), if it is available. This opens the door to many fund options.

2. Consider making your retirement plan more growth oriented and your outside assets more conservative. It is important to keep your overall risk level consistent with your risk tolerance, but you don’t have to have the same risk exposure in each account.

3. Reduce the duration of your 401(k) portfolio. This means selecting short term bond funds, preferably ones not limited to US treasuries. You may also increase your exposure to stable value or money market funds, even though returns could be modest. The goal of this strategy is to limit the downside, not capture return.

4. Utilize the most conservative target date fund as a portion of your allocation. These funds often have several underlying bond holdings in their index. But look under the hood. Not all target date funds are created the same, and simply owning these funds is no guaranty that you have a properly diversified mix of fixed income.

5. Ask your retirement plan provider if you are eligible for an in-service withdrawal. These withdrawals allow you to roll a portion of your 401(k) balance over to an IRA without incurring taxes. The distributions are plan specific (not provided in all plans) and age restrictions apply. Once in the IRA you could, presumably, select a conservative strategy with an eye on limiting interest rate risk.

Interest rates typically move in long term cycles – from bull markets to bear markets and back again – usually occurring over decades. We expect a bond bear market to begin sometime in the next year or two. It is not too early to start planning ahead; you and your 401(k) should be ready.