How Safe Are Your Bond Holdings?

(MoneyWatch)  Last week I wrote a post on how bonds can help keep you on track for retirement. But not all bonds are created equal. So this week I'm going to give you a few pointers to help you figure out if the bonds you own are safe enough for your retirement plan.

As I mentioned last week, bonds generally offer principal stability and consistent interest payments. This helps reduce the volatility in your portfolio, and gives you more control over your net worth.

But if the bonds you own go belly up, as in the case of General Motors and Lehman Brothers, then the plan starts to fall apart.

Credit Rating. The best way to check on the quality of the bonds you own is to review their credit rating. Individual bonds generally have their own credit rating and bond funds have what is called an average credit rating. Since most people own bonds through bond funds -- usually in their 401(k) -- I'm going to focus on the average credit rating.

The average credit rating is an estimate of the quality of the bonds in the fund that you own. Credit ratings go from AAA, the best, all the way down to C, which is about the worst. The U.S. government is rated AAA, as well as a few select companies.

Barclays US Aggregate Bond Index. So what type of rating should you look for on your bond funds? Well, there is no agreed upon standard, but a good benchmark is something called the Barclays US Aggregate Bond Index. This index tracks the holdings of what most professional investors consider the U.S. investment grade bond market.

• This index includes primarily U.S. government bonds and certain investment grade corporate bonds. And the average credit rating for this index is currently about AA, which is very high. It is a combination of US debt, which is AAA, and a number of select corporate bonds, which are on average roughly in the A range.
• In general, it's a good idea to benchmark your bond holdings off of the Barclays index. This means an average credit rating of somewhere near AA is probably a good place for most individuals to be, although the decision is always dependent on your individual circumstances.

So how did this index do last year when the markets fell apart? Well, the index was up about five percent for 2008. It's important to note that not all bonds in the index did well. Many corporate bonds went down in value, but they were offset by the increase in the value of U.S. debt. This is why diversification is also important with bonds.

As with all investment matters, past performance is no guarantee of future returns, but it's helpful to study the returns from last year for purposes of understanding risks in the stock and bond markets.

Check Your Funds. So how do you figure out the average credit rating of the bond funds you own? Most fund companies will include this information in their fund summary, or you can call and ask.

A prudent strategy is to look for funds that have a credit rating and investment allocation that is intended to track the Barclays aggregate bond index and that don't have much flexibility to deviate from that standard. Otherwise, an aggressive bond manager may end up taking more risk than you bargained for. This occurred with a number of bond funds in 2008.

Bottom line. Bonds offer good opportunities for principal stability and steady interest, as long as the issuers of the bonds can live up to their promises. To check the quality of your bond holdings, look at their average credit rating and monitor it on a consistent basis.

As with all investment matters, consult your individual advisor prior to making any investment decisions.

Photo from Flickr, courtesy of futureatlas.com, CC 2.0