Now that the Federal Reserve has announced it will start reducing its bond buying program by $10 billion per month, the impact is being felt in the financial markets. Stocks cheered the news, seeing it as confirmation that the Fed is growing more confident about the recovery of the US economy.
But the story for bonds is not so sanguine. The Fed news didn't set off a “taper tantrum” in fixed-income, but interest rates have started to creep up. I expect that to continue this year. After all, when the Fed weans the bond market off of its support, more investors will need to step in to buy these bonds and they will be sure to demand higher yields.
Since bond prices move in the opposite direction to yields, this means that bonds will fall in value. And if you own certain types of bond funds in your 401(k) plan, get ready to see some losses in 2014. That is, unless you make some smart moves now.
One of the most widely owned and largest bond funds in employer sponsored 401(k) plans is the PIMCO Total Return fund, with over $250 billion in assets. This fund saw a decline of about 2 percent in 2013. But the fund was actually up through April. It declined over 5 percent during the period from mid-May through the end of June. PIMCO bond guru and fund manager, Bill Gross has said bonds have seen their best days.
This is all bad news for investors who allocate more of their 401(k) accounts to bonds in hopes of reducing risk and locking in more stable returns. Many employer plans have education programs and call center reps who advocate that 401(k) investors should pick a suitable asset-allocation strategy that includes a mix of stock and bond funds and hold on, ignoring the current trends of the markets.
But following that advice and ignoring the fact that rates have been held (some say intentionally manipulated) to historically low levels by Fed policy -- and have nowhere to go but up -- can lead to outsize losses in certain types of bonds and bond funds.
The good news is that there are some moves you can make to avoid potential losses. Most 401(k) participants only have access to a limited number of bond funds and, as investors sell their shares, the fund managers are forced to sell bonds to raise cash for redemptions, which in turn drives bonds and bond fund values lower. Participants in 401(k) plans who hold bond funds need to reconsider this strategy and look for other alternatives. Here are a few options to consider:
Stable value funds: If your employer’s 401(k) plan offers a stable value fund, consider using it instead of any bond funds. These funds are typically managed by a bank or insurance company that pays a stated interest rate for a set period. Stable value funds provide a low but fixed interest rate and a provide stability and safety of your principal.
Short-term bond funds: If your 401(k) plan does not offer a stable value fund, then look for a bond fund with a low duration, or average maturity of its bond holdings, of less than five years. For example, while the PIMCO Total Return Bond fund declined 2.5 percent in 2013, the PIMCO Low Duration Bond fund, which owns a portfolio of bonds with a shorter duration, only declined about a half of one percent. Short-term bond funds will hold up better during times when rates are rising.
401(k) self-directed account: So what can you do if your 401(k) plan doesn't offer a stable value fund or a short-term bond fund? Many 401(k) plans offer a self-directed brokerage account. If your plan offers this option, then open the brokerage account and transfer some of your 401(k) account into that. Brokerage accounts in 401(k) plans offer thousands of additional fund choices, including a wide variety of short-term bond funds, individual stocks and bonds.
Finally, many 401(k) participants allocate their accounts in target-date retirement funds, which are prepackaged funds which include a mix of cash, stock and bond funds. These funds then glide down or rotate the allocation out of stock funds and into bond funds as the target date of the fund nears. Because these funds will own bond funds, they can also get hurt by rising rates.
Consider creating your own allocation of stable value funds, short-term bond funds and stock funds instead. Not only can this personalized allocation strategy help to reduce losses, participants who do this can see the actual performance of each fund they own and follow the performance as rates continue to rise in the future.