Should I Add Bonds to my 401k?


Jeffery Bogle, founder of Vanguard mutual funds, is credited with what has been come to be known as the “Bogle rule,” which says that you should invest your age in bonds.   In other words, if you’re 25, you should have 25% of your investments in bonds and the other 75% in stocks.  If you’re fifty, you should be 50%-50%.  The idea is that as you get older and closer to needing the money, you should add bonds since they have a more predictable rate-of-return than stocks and will hold up better in down markets since the interest payments they provide will both offset any loss in price, plus will tend to keep the price from going down as much.

In addition, if you hold a bond until it matures, no matter where the price has gone during its lifetime, the company or government that issued it will pay you the face value, usually $1,000 per bond for corporate bonds.  Because of this, the closer to maturity the bond is, the closer it will stay to the redemption value.  If you buy short-term bonds (or a short-term bond fund), the potential return you’ll receive will be less than you’ll find with long-term bond funds, but the volatility of their price will also be less since the bonds will be near redemption.

The issue with holding all bonds is that your return will be less than it will be with stocks over long periods of time (about 5-8% versus 10-15% annualized per year).  With a middle-class salary, if you contributed 15% of your salary to your 401k but only bought bonds  your whole career, you’d end up with millions of dollars less than someone who put all of their money into stocks for the first thirty years.  Holding 100% bonds can also make your portfolio more volatile during periods where interest rates are rising rapidly or inflation takes off because bond prices are very sensitive to changes in interest rates and inflation.  It is therefore safer to have a portfolio consisting of 80% bonds and 20% stocks than a 100% bond portfolio.

So with bonds, you tend to want to add them to your portfolio as you get closer to needing the money, which is usually your retirement date.  The Bogle rule assumes that you always want a few bonds, just to reduce volatility, but that you’ll want to have the majority of your assets in stocks until you’re entering retirement.   Having some stocks even in retirement is needed because it helps fight inflation, keeping your spending power from declining late in retirement, so even at age 70 you would still have at least 30% of your portoflio in stocks.  As you got older, you’d sell some of those stocks and buy more bonds to increase the amount of cash you’d receive each year to make up for the reduction in spending power you’d have if you kept receiving the same amount of cash each year due to inflation.    Because life expectancies are longer than they used to be, such that people are living twenty to thirty years into retirement, the Bogle rule has also been adjusted to “buy your age minus 10% in bonds” so that you’ll have a bit more in stocks when you enter retirement.

An alternative to having bonds in retirement is raising cash by selling stocks and putting the money into a money market fund or bank CDs.  Because it is very rare for the stock market to be down for more than 5 years, and because the level of declines that do extend beyond five years tend to be very minor, having five-years worth of cash in your portfolio can help you avoid needing to sell right after a market crash because you need to raise cash.  This kind of strategy, where you have a larger cash position and forego bonds, can make sense at times like right now where interest rates are very low, such that bonds really aren’t paying enough to generate enough income for living expenses, and rates are expected to rise.  You can also mix in alternative income investments to bonds, such as high dividend paying stocks like utilities, real estate through REITs or by buying rental properties directly, and investments like limited partnerships which pay out a large percentage of the money they make through pipelines and the like.  (Be cautious with this last one, as you could end up filing taxes in multiple states with limited partnerships.)

Good times to buy bonds are the following:

  1.  You’re nearing retirement (age 45+) and interest rates are in the range such that quality bonds are paying at least 5-6% with junk bonds paying in the 8-10% range.  Savings accounts would be paying 2-3% interest.  In this case you might be able to generate enough income from interest payments to avoid needing to sell stocks or bonds to raise cash for living expenses.
  2. Interest rates are very high, such that even quality bonds are paying in the 10% plus range and rivaling the potential returns from stocks.
  3. Interest rates are relatively high, the economy is slowing, and interest rates are therefore likely to begin heading down.

If at least one of these conditions were not met, I would probably forego buying any bonds until I was within about five to ten years of retirement since the returns I would get from the stock market would be so much better.   I instead would accept the larger volatility in exchange for the better returns.  Then again, I have an iron stomach when it comes to stock market fluctuations, knowing that as long as I have several years until I need the money that the market will likely come back from any drop.  If seeing your portfolio decline in value really affects you, however, such that it would make it hard to sleep at night, mixing in a few bonds even early in life with the understanding that you’re reducing your future returns in exchange for less volatility may be worth the sacrifice.

Finally, if you buy a target date retirement fund, they do the bond/stock ratio adjustments for you.  Just pick a portfolio with a date near when you will retire and let it go.  If you want to be a bit more aggressive, pick a date ten years after you’ll retire.  If you want to be more conservative and reduce volatility, pick one ten years before you retire.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.


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