High Time to Clear Up Wrong Ideas About Bonds

With interest rates on the rise--last week, the benchmark 30-year Treasury bond yield crossed the 6% threshold, a level not seen in more than a year--it’s a good time for investors to shift focus to bonds and bond mutual funds.

As in, what do we do with these things?

The vast majority of 401(k) investors haven’t a clue, recent surveys show:

Misconception No. 1: Two out of five of us believe that the most advantageous time to invest in bond funds is when interest rates are expected to rise, rather than when they’re expected to decline, according to a recent survey by John Hancock Financial Services.

Wrong. For those who don’t know (which is about 85% of investors), here’s why:

Bond prices move in the opposite direction from market interest rates. When market rates rise, what do you think happens to the value of older bonds carrying lower fixed rates? That’s right--they fall in value. And sometimes, that drop in principal value more than offsets the interest earned on the bond in a given period--which means that investors, on paper at least, are losing money on the investment.

Which brings us to . . .

Misconception No. 2: Bond mutual funds can’t lose money.

If you think bond funds can’t fall in value, look around. In May, as market rates rose, 94% of all bond funds posted negative “total” returns, according to fund tracker Morningstar Inc. That is, the yield earned by most funds was less than the drop in fund principal value for the month.

And year-to-date, as long-bond yields have shot up nearly a full percentage point, the total return of the average domestic bond fund now is a negative 0.6%. The average stock fund, by contrast, has gained 6%.

In 1994, when the Federal Reserve, in a series of six steps, doubled short-term interest rates, the total return of the average bond fund was negative 3.7%, according to Morningstar.

Does this mean you should turn your back on bond funds right now? Not necessarily. If you’re convinced that rates won’t go much higher than this, and if you’re a firm believer in buying low and selling high, yields are certainly much more attractive today--meaning bond prices are far lower than at the beginning of the year.

But do you need bonds? That brings up . . .

Misconception No. 3: At some point, as you accumulate assets in your 401(k), you must invest some of it in bonds.

“Not necessarily,” says Carol Gleckman, director of KPMG’s investment consulting practice in Los Angeles.

For some 401(k) investors, it’s not even possible to buy bonds. The latest survey by research firm Spectrem Group found that only 54% of 401(k) plans last year featured a bond fund among their investment options.

What’s more, even in plans with bond fund options, the few choices offered--such as government bond funds, or corporate junk bond funds--may be poor or inappropriate for many investors.

You need to ask yourself: Why invest in a bond fund at all?

A key reason to own bond funds within a 401(k) is to stabilize your overall portfolio, providing more of a capital-preservation feature. Over time, bond funds won’t deliver the returns that stock funds can, but neither are bonds as volatile as stocks, especially in the short run.

Bond funds “act as shock absorbers,” notes Wayne Gates, general director for John Hancock Mutual Life Insurance Co. in Boston.

But are bond funds the only shock absorbers in your 401(k) plan? Maybe not. And are bond funds the best at absorbing any shock to your 401(k)? Once again, maybe not--especially in periods of rising interest rates.

Money market funds, or even stable-value funds (which invest in individual “guaranteed investment contracts” that promise a certain rate of interest) are less volatile than a typical intermediate-term or long-term bond fund.

Between 1983 and 1998, the standard deviation (a measure of volatility) of the typical intermediate-term bond was about 5.1%. That compares with 2.3% for some stable value funds and 1.9% for money market funds.

OK. But if you put money that you otherwise would invest in a bond fund into a money market fund, it won’t grow as fast. True?

That’s true. Over the last 10 years, the typical intermediate-term bond fund has delivered gains of about 8% a year, while you were lucky to see 5% annual yields on a money market fund.

But remember, if this is “shock absorber” money you’re dealing with, overall returns aren’t your top priority. What’s more, says Hancock’s Gates, you don’t necessarily have to give up return on your overall portfolio by putting a “bond allocation” into a money market fund instead.

Gates notes that between 1983 and 1998, a portfolio consisting of the classic 60% stocks and 40% intermediate-term bonds delivered annualized gains of 15% with a relatively low standard deviation of 9.44%.

That same level of volatility and returns would have been achieved by putting 27% of your money in a money market fund and 73% in stocks, he says. And the same level of volatility, and slightly higher returns, would have been achieved by putting 26% of your account in a stable value fund and 74% in stocks, Gates adds.

Now, if you have a good bond option in your 401(k)--a fund that has produced above-average returns with below-average risk--investing in that fund may be a fine way to stabilize your portfolio.

But while bonds certainly can be good investments within a 401(k), if you don’t have a good bond option, you may be able to achieve your capital-preservation/shock-absorber goals with money funds or stable-value accounts just as well.

Do you have ideas for mutual fund and 401(k) topics for this column? Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.