The Wrong Way To Invest In Bonds

The Wrong Way To Invest In Bonds

Most 529 and 401(k) plans offer a pretty broad range of U.S. stock mutual funds. There are large cap funds, small cap funds, value and growth funds, actively managed vs. passively managed funds, and occasionally even industry sector funds. When it comes to bond funds, however, most plans limit you to just one fund that tracks a single bond index (typically the Bloomberg Barclay’s Aggregate Bond Index, also known as the Agg). I find this completely backwards.

During the early years when you are saving for college or retirement, it is certainly beneficial to invest in funds focused more on growth than on asset protection. That means putting more into stock funds than into bond funds. But unless you believe in the magic of always being able to pick stocks that will outperform the broad market, you don’t really need a lot of stock funds to achieve sufficient diversification.

On the other side, the balance between protection and growth becomes significantly more important as you approach the time when you need to access the money. The role of bonds is primarily to help you diversify the risk. There are at least a dozen different types, each of which behaves differently in different economic situations. Unlike with stocks, bond pricing is more determinable, and consequently price volatility is more subdued. By selectively allocating your investments to the appropriate bond funds based on prevailing interest rates, credit risks, and other factors that favor one type of bond over another at any given time, you are more likely to achieve the growth/protection balance needed both before and during the time you start withdrawing the money. Unfortunately, your 401(k) or 529 is not likely to provide you with access to the dozen or so bond funds you’ll need to accomplish this.

The problem with the Agg index, despite it being the longest-lived and most popular bond index in the country, is that:

  • It represents only about half of the total available bond market. The Agg is 37% U.S. treasuries, 30% U.S. agency mortgages, 26% corporate bonds, and 7% other U.S. government-related bonds, but does not include senior bank loans, non-agency mortgages, and munis, just to name a few. Furthermore its duration is nearly 6 years, meaning that a 1% increase in interest rates would cause a 6% drop in its value. That can be problematic during periods of rising rates such as the environment in which we find ourselves today.
  • It is one-size-fits-all which does not allow you to granularly adjust either the types or the durations of your bond investments as indicated above. That’s a little bit like trying to make pancakes with a pre-formulated mix of ingredients as compared to mixing each of them yourself in proportions more appropriate to taste as well as based on climatic conditions. Can you imagine a professional cook using Bisquick?

The misplaced reliance on the Agg for bond diversification is not limited to college savings and retirement plans. Although most brokerage and IRA account custodians provide access to a wide array of bond funds, I still frequently come across portfolios holding a myriad of stock funds and ETFs but just one Agg-based fund for bonds.

The U.S. bond market – currently valued at over $40 trillion – is larger and more diversified than the U.S. stock market. Although you may not have much choice when it comes to your 401(k) or your 529 plans, you should consider skipping the Agg-based funds in your other accounts and instead learn about and take advantage of all the different bond funds available in order to better manage your portfolio’s risk/return balance. It’s one of the most important moves you can make, especially if you are over 50 years old and slowly nearing retirement.

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