Can Bonds Help Maximize Your Retirement Planning?
Over the past several months we’ve fielded calls from Smart401k clients concerned about investing in bonds. The main reason: interest rates are at historically low levels and seem to have only one way to go – up. While this concept is generally true, the fact is all bonds are not created equal. First, let’s recap the basics so we can move on to how this fits with a retirement plan strategy: when interest rates go down bond prices typically go up – a seemingly good thing for the bond investor. When interest rates go up the price of bonds will fall.
Now, keep in mind, in many cases retirement investors are exposed to bonds through a bond fund representing a group of bonds rather than a single position. Typically the bond funds offered in 401(k)s and other work retirement plans are actively managed by a fund manager overseeing the portfolio and making changes according to developments in the economy and the market. This means that fund managers can make changes in the portfolio to lessen the negative effects that rising interest rates can have on existing bonds.
In addition, the types and duration of bonds are numerous, giving way to varying reactions to the market. For example, bonds with shorter terms to maturity will be less sensitive to changes in interest rates than longer term bonds; and, bonds with higher coupon or interest rates will be affected less than their lower rate peers.
Most bonds have two components that contribute to their performance: the price of the bond and the coupon or interest rate. These components serve to provide diversification to a portfolio or current income depending on whether an investor is in the accumulation or distribution phase of their life.
Since most people thinking about retirement planning are in the accumulation phase of their lives, let’s look at the effect bonds have historically had on volatility by comparing portfolios containing an allocation including bonds with a portfolio of all stocks*.
| 100% Equity Portfolio
(1960-2009)
|
90% Stocks / 10% Bonds
(1960-2009)
|
70% Stocks / 30% Bonds
(1960-2009)
|
| Annualized Return= 10%
|
Annualized Return= 9 %
(-10%)
|
Annualized Return= 9%
(-10%)
|
| Mean Return= 12%
|
Mean Return= 11%
(-8.3%)
|
Mean Return= 10%
(-16.6%) |
| Standard Deviation= 21%
|
Standard Deviation= 19%
(-14.25%)
|
Standard Deviation=15%
(-28.6%) |
*Institute of Business & Finance, Quick Reference Guide-Asset Allocation (www.icfs.com) 2010. Negative values indicate the reduction in volatility and return that bonds provide.
The reduction in volatility can be attributed to the fact that bonds have a very low correlation, and in some cases a negative correlation, to other asset classes. In simple terms, adding bonds to your portfolio can smooth the ups and downs of the stock market without dramatically effecting returns.
At Smart401k we establish detailed recommendations including some allocation to bonds for all but our most aggressive investors. To limit the risk of default and the effects of interest rate fluctuation we use high-quality, medium-duration bonds whenever possible. In some cases we find that a large allocation of bonds is necessary to reduce volatility to levels appropriate for conservative investors. In these cases we try to include exposure to multi-sector or high-yield bonds to achieve diversification within the bond position.
Our clients find this guidance valuable because many retirement plans offer a variety of bond options, some of which can be quite volatile and should only be held as small complimentary positions. Investors often gravitate toward the riskiest bond funds, seeing higher returns in a positive market that give the impression the bond funds are safe and lucrative at the same time.
In recent news there has been talk of a “bond bubble” that is important to put in perspective. Most of the concern surrounding the formation of a bubble in bonds is centered on the treasury markets. Treasuries are bonds issued and guaranteed by the U.S. government. Investors afraid of the current volatility in the stock market are flocking to treasury bonds for safety, and as a result the interest rates in this segment are falling. It is a simple case of supply and demand. The current surge in demand has pushed yields lower. Once investors decide to return to the stock market, they will look to sell treasuries causing a surge in supply and force the sellers to take lower prices. This is exactly why we recommend that our clients invest in a variety of bonds with a portion of their investment.
The perceptions that investors have about investing in bonds vary. Some conservative investors believe bonds cannot decline in value, while some aggressive investors think bonds have no place in their portfolio. The truth is bonds can be an effective tool to produce income, but they are not risk free; and most bond funds are not as aggressive as some other options, and they can reduce the volatility of a portfolio without dramatically effecting returns. The amount of bonds appropriate for your portfolio depends on your specific investment objectives.
If you have questions or would like to further discuss how bonds may benefit your portfolio, feel free to contact me at ckoch@smart401k.com or any of our adviser team at info@smart401k.com or 877.627.8401.
About Smart401k
Smart401k is a Web-based investment adviser providing unbiased advice to help employees invest in their employer-sponsored retirement plans. Smart401k provides service to almost 11,000 clients who collectively have more than $1.5 billion in assets. Individuals receive personalized investment recommendations based on the funds in their plan and support of professional investment advisers available to answer all investment questions. Based in Overland Park, KS, Smart401k can be found at Smart401k.com.
