Most 529 college savings plans and 401(k) company retirement plans offer a pretty broad range of U.S. stock mutual funds. There are large-cap funds, small-cap funds, value and growth funds, and even sometimes actively managed versus passively managed funds.
When it comes to bond funds, however, many such plans limit you to just one fund that tracks a single bond index – typically, the Bloomberg Barclays Aggregate Bond Index, also known as the Agg. This is backward. They should be providing more choices for bond funds than for stock funds.
When college or retirement is many years away, it is certainly beneficial to invest more of your savings in higher-growth stock funds than on less volatile but slower-growing bond funds. But unless you believe in the magic of consistently being able to pick stocks that will outperform the market, you don’t really need a lot of stock funds to achieve sufficient diversification. A few basic index funds should generally do the trick.
As you approach the time when you need to access the money, however, the balance between asset protection and growth becomes significantly more important. That means a higher proportion of your savings should be shifted to fixed-income investments (bonds and bond funds).
But there are many different types, each of which responds in different ways to current levels of and future changes to interest rates, credit quality and exchange rates. By simply allocating what at this point has become the bulk of your savings to a single bond index fund, you are potentially taking on more risk and may be receiving less growth than if you were to manage that portion more granularly.
The Agg index, despite it being the longest-lived and most well-known bond index in the country, represents less than half of the total available bond market. It currently comprises 37 percent U.S. Treasuries, 30 percent U.S. agency mortgages, 26 percent U.S. corporate bonds and 7 percent other U.S. government-related bonds. It does not include senior bank loans, nonagency mortgages and municipal bonds, not to mention foreign sovereign and corporate bonds.
Furthermore, its duration is nearly six years, meaning that a 1 percent increase in interest rates would cause a 6 percent drop in its value. That can be problematic during periods of rising rates such as the environment in which we find ourselves today. Using the Agg to represent the bond portion of your portfolio is a little bit like trying to cook a meal using a pre-formulated mix of ingredients as compared to choosing each of them yourself in proportions more appropriate to your taste. Can you imagine a professional cook making pancakes using Bisquick? (Please note that I have no complaint with Bisquick!)
The U.S. bond market – currently valued at more than $40 trillion – is larger and more diversified than the U.S. stock market. Although you may not have much choice when it comes to selecting bond funds in your college savings and company retirement plans, you should consider taking advantage of the many different types of bond funds available in your other accounts to better customize your portfolio to meet the risk/return balance unique to your future goals. It’s one of the most important investment moves you can make, especially if you are nearing retirement.