Bonds Are Risky Now in Your 401(k)

In early October of 2011, the yield on the benchmark 30-year Treasury fell to a low of 2.69 percent. At around the same time, the yield on the 10-year Treasury note fell to 1.69 percent.

As an experiment, I asked my teenage son if he would loan me money for ten years at 1.7 percent. His response was, “That sounds like a good deal for you and a bad deal for me, Dad.” That kid is going to make it big in business someday!

With current inflation rates somewhere around 3.7 percent, loaning money to the U.S. Government Treasury Department now is a guaranteed losing investment for the next ten years. A 10-year government bond investor would not get paid back in interest an amount that would keep up with the annual cost of living increases over the next ten years!

The potential for dramatically rising interest rates is something that company 401(k) retirement plan investors have not had to deal with since the 1970’s. Lately, I have had to reeducate some company retirement plan participants about what happens to the price of bonds (and mutual funds that own bonds), when interest rates rise.

When interest rates go up, bond prices fall in value because bonds with higher interest rates are more attractive to investors than bonds with lower interest rates.

The annual interest rate you receive on your bond mutual fund investment stays the same as long as you own it. However, when interest rates rise, the price per share of your bond mutual fund falls.

Bond mutual funds are “advertised” as being a safe and secure part of the “diversification” of your company retirement plan account. That will not be the case when interest rates begin to rise sometime in the future.

There is no long-term economic benefit in your 401(k) account to own a bond fund that currently pays a 4 percent annual yield when at some point in the future the price per share of the same mutual fund goes down 5 percent.

To ask an even more extreme question, would good would it be to find a company retirement plan investment that provided a 10 percent annual yield if in the future you had the risk of losing 20% of your original investment?

This is the long-term investment management question to ask now about your current bond mutual fund investments Don’t focus some much on the current annual return. Instead concern yourself about the preservation of your 401(k) principal when interest rates rise again.

Bond mutual funds have held theirprice per share values lately, and some have even risen in value over the last two years. But there is no way that trend will continue when, not if, interest rates begin to rise in the future.

I am not smart enough to begin to tell you when interest rates will rise or what set of economic events will make them rise. And I can’t begin to tell you how much they will rise. But I do know enough about bonds to advise you that you are currently taking much more investment risk owning bond mutual funds in your company 401(k) plan than you probably realize.

Ric Lager
Lager & Company, Inc.