Q: With interest rates predicted to rise in 2015, what should I consider doing with my mutual fund bond holdings now? About 35% of my retirement portfolio is in bonds as part of a target date retirement fund. — Alan in Orland Park, Ill.
A: No doubt this is a common concern for many investors today. Economists have for years been saying that interest rates can only go higher from here, and yet interest rates are still near historic lows. The yield on the 10-year Treasury note has been hovering around just 2% — and that’s down from 3% at the start of last year.
Why the worry? Market interest rates and bond prices move in the opposite direction. So a rise in interest rates would likely translate to a drop in the value of older bonds held by your bond funds. Trouble is, exactly when rates will rise and to what degree is still anyone’s guess.
“We all know the elephant in the room is that rates will go up,” says Jason Jenkins, an investment advisor and CEO of portfolio monitoring software company AssetLock. “But I don’t think they will respond as violently as everyone thinks.”
Jenkins isn’t alone in that view that interest rates won’t shoot up over night. While it’s true that the end of the Federal Reserve’s stimulative bond-buying program reduces domestic demand for Treasuries — which lowers prices and in turn raises rates — foreign investors have been flocking to U.S. bonds of late amid worries of another global slowdown.
Regardless of what happens in the big picture, it’s important to view this in the context of what role bonds play in your overall portfolio.
If you’re in or near retirement, odds are that you’re looking to bonds for steady income. In that case, rising rates will ultimately be to your benefit. “Investors need to remember there are two sides to the coin,” says Jenkins. “If rates go up, prices go down but payments go up.” In 1999, for example, the Barclays U.S. Aggregate index fell 7%, but the yield was 6.7%. Investors, adds Jenkins, need to think not just about price and yield but total return.
Meanwhile, bonds bring something else to the table – diversification. Historically, when stocks are at their worst, bonds have still managed a positive return. In one study, Vanguard looked at periods of bottom-decile returns for U.S. stocks from 1988 through 2012. During those times, the median monthly return bonds — including Treasuries, U.S. corporate bonds and international corporate bonds — was still positive.
That said, Jenkins and bond strategists aren’t advocating investing in bonds indiscriminately. Because long-term bonds are most vulnerable to rising rates, he recommends sticking with short-term and intermediate-term bonds.
Now, your question of what to do with bond holdings raises a couple of other points: Should you be in a target date fund, and if so, are you in the right target date fund?
Target-date funds are a handy solution for investors who would otherwise make poor investment decisions, try to time the market, or not invest at all. In theory, you could choose such a fund pegged to the year you think you’ll retire and never worry about where to invest or when to rebalance. The managers of these funds will make those decisions for you.
Yet as many investors in these funds learned after the financial crisis, one-stop-shopping isn’t a perfect solution. Two funds with the same target date may take two very different approaches — one risky, one conservative. Moreover, your own propensity for risk is as much of a factor as the date you expect to retire.
If you’re concerned, at the very least do look under the hood (sounds like you have) and see what percent of your portfolio is in bonds and the maturity of those bonds. You can use some of the free tools at Morningstar.com to see how your fund did relative to similar portfolios in 2008 and get a closer look at where it’s invested today.