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Protect your 401(k) from rising rates

(MoneyWatch) It's been a good year for stocks. U.S. stock indexes are up over 13 percent through June.

For bonds, though, the story is not so good. Recent testimony by Federal Reserve Bank chairman Chair Bernanke about the possibility of the the central bank's tapering its bond purchases set off a "taper tantrum" in the bond market.

The yield on the all important 10-year Treasury rose from about 1.6 percent in early May to about 2.6 percent now. Since bond prices move in the opposite direct to yields, these bonds fell about 3.5 percent in value. Which means that if you bought a 10-year Treasury bond with an interest rate of 1.6 percent in May, the loss in value over the past six weeks is more than the interest you'll receive over the next 30 months.

One of the most widely owned and largest bond funds in employer-sponsored 401(k) plans, the PIMCO Total Return fund, with more than $285 billion in assets, has witnessed a decline of over 3.6 percent to date this year. The fund was actually up through April but declined more than 5 percent from mid-May through the end of June! PIMCO bond king and fund manager Bill Gross has said bonds have seen their best days.

Why does this matter to 401(k) investors? Well, for starters, people who prefer to allocate a higher percentage of their 401(k) investments to bonds do so to reduce risk and lock in more stable but lower returns. Second, 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 those who follow that advice and ignore the fact that since Fed policy has held rates at historically low levels, they have nowhere to go but up may set themselves up for outsize losses. But these are avoidable. Participants in 401(k) plans holding bond funds find themselves vulnerable when investors sell their shares, forcing fund managers to sell bonds to raise cash for redemptions. This in turn drives bonds and bond fund values lower. Accordingly,  investors in 401(k) plans with bond exposure should 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 choosing it over any bond offerings. Banks and insurance companies typically mange these funds, paying a stated interest rate for a defined period. 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 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 has declined more than 3.6 percent so far this year, the PIMCO Low Duration Bond fund, which owns a bond portfolio with a shorter duration, has lost about 1.7 percent. Short-term bond funds hold up better when rates are rising.

Target-date retirement funds: These are prepackaged funds that include a mix of cash, stock and bonds. Their managers glide down or rotate the allocation out of stock funds and into bond funds as the target date nears. Since these funds have bond holdings, rising rates will affect their performance. As an antidote, it is advisable that investors determine their own allocation of stable value, short-term and stock funds. Such a personalized allocation strategy not only helps reduce losses, but it allows 401(k) participants to gauge the performance of each fund they own and keep an eye them as rates continue to rise.