Retirement plan decisions made easy
Drill Down: Investing Your Bond Money
Put your bonds into a short or intermediate mutual fund if you have that choice. However, if your only bond option is a long-term bond, then split your bond money half and half between a money market mutual fund and the long-term bond fund.
The risk of a bond is greater the longer the maturity of the bond. A bond that pays you back in 30 years is riskier than a bond that pays you back in one year. Some of that risk is obvious. If the bond is issued by a corporation, you may wonder whether that company will actually be able to pay you back or not. New technology could be developed that would make that company obsolete. A lot can happen in 30 years, but not as much can change in only one year.
The greater source of risk for bonds, though, is changes in interest rates. Think of it this way. Once you buy a bond, it’s an “old” bond. After interest rates change, whether they rise or fall, potential investors will be comparing the interest rate on your old bond with what they can receive on new bonds. If you bought your old bond at an interest rate of six percent, but the new bonds are offering seven percent, investors aren’t going to like your old bond very much. They’ll buy it, but only at a lower price than you originally paid for it. A drop in interest rates, however, makes your old bond more valuable. If you originally purchased a six percent bond and then interest rates dropped down to five percent, investors will look at your bond as a great beauty. They’ll pay you a premium price to own it.
How much your bond changes in value depends on both the level of interest rates and the maturity of the bond. (Maturity is how many years until the bond is paid back.) There’s a calculation that can be made on a bond, or a mutual fund full of bonds, called “duration.” The longer the duration, the greater the risk the bond holds.
For the bonds you put into your 401k, I’d like to see a duration of about two or three years. That’s what you’ll see in a typical “short-intermediate” bond fund. There’s not much risk in such a short duration.
But a long-term bond fund may have a duration of six years or more. That’s more risk than I’d like you to take on the bond portion of your portfolio. To get a lower level of risk, blend a long-term bond fund with a money market mutual fund to get the duration you want.
Here’s the advice:
- If you have a short or intermediate bond fund as one of your choices, use it for your bond allocation.
- If you do not have a short or intermediate bond fund option, split your bond money between a long-term bond fund and a money market mutual fund.
If you need to blend together a long-term bond fund and a money market fund, here’s how to figure out the proportions. If you want to keep things simple, split your bond investment half and half between the long-term bond fund and a money market mutual fund. If you are willing to do a little arithmetic, here’s my suggestion. Try to find the duration of the fund that you can invest in. It may be buried in a table describing the fund’s investments. (It may be labeled “modified duration.”) You’ll blend this bond fund with a money market mutual fund to get the resulting mix down to a duration of two. To find the correct proportion, divide two by the duration of the bond fund. For example, if the bond fund has a duration of 5.0, then take 2.0 divided by 5.0 to get 0.4. That tells you to put four-tenths of your bond money into the bond mutual fund and the rest into the money market mutual fund. (For those of you mathematically inclined, the money market fund has a duration of approximately zero.)
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
» Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
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