Don't let rising interest rates sink your 401(k)

Anyone saving for retirement in a 401(k) or IRA can't help but notice how much stock funds have been going up. In 2016, the S&P 500 index notched gains of nearly 12 percent, and so far this year, the broad stock market benchmark is up over 7 percent.

But the story for bond funds is mixed. The Barclays US Aggregate Bond Index, a good proxy for the bond market, posted smaller gains of 2.6 percent last year and about 1.6 percent so far this year. To be fair, it's no surprise that over long periods of time bond funds will underperform stocks. But when stock markets are down, bond funds can hold value, so owning bond funds can reduce risk, diversify your portfolio and be a sound investment strategy.

However, many bond funds could be poised to deliver losses to investors because the Federal Reserve is widely expected to stick with its interest rate hikes this year. Wall Street pegs the year-end rate on the 10-year Treasury, currently at 2.3 percent, to be about 3 percent. 

Since bond prices move in the opposite direction of yields, this means broad market bond funds could decline about 3.5 to 4 percent in value from now through December. Some bond funds could lose more in the next seven months than they've earned in the last two years.

Why does this matter to 401(k) investors? Most people who tend to allocate more of their 401(k) accounts to bond funds do so to reduce risk and lock in more stable (albeit lower) returns. Also, call center reps and education programs provided in connection with many employer retirement plans advocate that participants ignore daily market trends and instead pick an asset-allocation strategy that includes a mix of stock and bond funds, and hold on.

But if you follow that advice and ignore what's happening with interest rates, it could mean losses in your 401(k) that can be avoided. Also, bond funds can be riskier than owning individual bonds. That's because when bond fund investors see losses, many will sell their shares. The fund manager is then forced to sell bonds to raise cash for shareholder redemptions. This pushes the bond fund shares lower. 

But when you own an individual bond (typically not available in retirement plans), you can hold it until maturity, so it's not affected by fund redemptions. Participants in 401(k) plans who hold bond funds should review them now and look for alternatives that aren't as buffetted by rising interest rates. 

Here are a few options to consider:

Stable value funds: If your 401(k) plan offers a stable value fund, consider using it in place of owning any bond funds. These funds are typically managed by a bank or insurance company and pay a stated interest rate for a set period. Rates are typically in the 2 percent to 3 percent range right now. They provide a low but fixed interest rate and a promise of a stable principal value.

Short-term bond funds: If your 401(k) plan doesn't offer a stable value fund, look for a bond fund with a duration (the average maturity of bond holdings) of less than five years. Short-term bond funds will hold up better during times when interest rates are rising.  

Finally, many 401(k) participants use target-date retirement funds in their accounts. These are prepackaged funds that include a mix of cash, stock and bond funds. Over time, these funds adjust the allocation mix out of stock funds and into bond funds as the target date nears. Because these funds will own bond funds, they can also get hit by rising rates. 

As an alternative, consider creating your own allocation of stable value funds, short-term bond funds and stock funds. This personalized allocation strategy can help reduce losses. And when you do this, you can monitor the performance of each fund you own and know how each fund performs as rates continue to rise in the future. 

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.