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 Retirement investors have enjoyed the best of both worlds these past
two years: a bull market in both equities and bonds. But the bond
market has been weathering volatility and sharp declines since late
April, with prices falling and yields rising.
Bond experts are not certain that the bond party is over yet, but
the recent volatility raises a question: should 401(k) investors
take steps to protect themselves in the event of a sharp spike in
interest rates and accompanying fall in bond valuations?
Experts do not think so. Unlike the world of active bond traders,
retirement investing is a long-term game. Although the price of
bonds moves in the opposite direction to their yield and hence
fluctuates, principal always is returned if the bond is held to
maturity.
And most 401(k) investors are in bond mutual funds for the fixed
income portion of their portfolios, which are highly diversified and
usually invested in intermediate (five-year) high-quality government
and corporate bonds.
"If investors stay course and their holding period is longer than
the fund's duration, rising rates should be not much to fear," says
Fran Kinniry, a principal in Vanguard's Investment Strategy Group.
Kinniry adds that the enduring low-rate environment has led
retirement investors to change their view of the role bonds play in
their portfolios. For a very long time, they saw bonds as an asset
class delivering yield. But with such a low rate environment, the
real role of bonds is to truncate or reduce equity risk, especially
for older investors and retirees, who still may have 30 or 40
percent of their assets in equities.
As a result, retirement investors have taken the recent bond market
volatility in stride. "We're not seeing any real dramatic cash flow
out of fixed income," Kinniry says.
Automation is another key factor reducing the drama of the bond
market's volatility.
About half of all 401(k) plans now offer one-on-one financial
counseling, online advice or managed account services, according to
Aon Hewitt, and roughly 10 percent of workers at those firms are
taking advantage of the services. A bigger trend is the investor
shift to target date fund (TDF) series, which follow predetermined
asset reallocations based on a specified expected retirement date,
with a shift toward income as retirement gets closer.
TDFs weight younger investors' portfolios heavily toward equities,
and that is reflected in overall market data. Just 5 percent of all
401(k) assets held by participants in their 20s were in bond funds
in 2013, according to the most recent data from the Investment
Company Institute (ICI). By contrast, 11.6 percent of assets held by
account-holders in their 60s were in bond funds.
But TDFs, and other managed account services, also aim to improve
the behavioral aspects of retirement investing, removing the
inclination to react to sharp price swings or to time the market.
ICI reports that 71 percent of 401(k) plans offered TDFs in 2013,
and that 41 percent of account-holders had at least some assets in
them.
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Keeping funds balanced leads to positive results. Vanguard
historical analysis shows that a portfolio of 55 percent equities
and 45 percent bonds has had an average annual return of 8.58
percent since 1926, compared with 10.24 percent for stocks. The
worst annual return was a negative 24.6 percent, compared with
negative 43.1 percent for stocks only.
A small number of TDF series are using nontraditional bond funds,
which take short bond positions to protect against rising interest
rates. This is a small but growing trend. Eight out of 50 TDF series
tracked by Morningstar are using nontraditional bond funds, and none
of the big three players, Vanguard, Fidelity and T. Rowe Price,
employ the strategy. "They actually benefit if rates rise," says
Jeff Holt, a fund analyst at Morningstar. "But if rates continue to
fall or don't rise, you run risk."
If you are near retirement and the bond market is keeping you up at
night, you could diversify some of the nonequity portion of your
portfolio, suggests Lucas Turton, chief investment officer at
Windham Capital Management. If you are 30 percent in bonds, move
half of that to cash (a money market fund) or a stable value fund,
he says.
"I'm suggesting a move toward safety and higher security, but it's
difficult advice to take because it guarantees a negative real
return. The alternative is taking interest rate risks and perhaps
seeing bond and stock prices fall simultaneously," he adds.
Longer term, a return to a higher-rate environment would be very
positive for retirees, who depend on bonds and even certificates of
deposit for income. They have been suffering through an extended
yield drought ever since the Great Recession.
Vanguard's Kinniry thinks rates ranging from 2.5 percent to 4
percent could be in the offing. "But we're not seeing any signal
calling for runaway bond yields," he says.
(The writer is a Reuters columnist. The opinions expressed are his
own.)
(Editing by Beth Pinsker; and Peter Galloway)
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