There used to be a simple rule of thumb for retirement savers: The percentage of bonds in your portfolio should match your age. So a 65-year-old would have 65% of her retirement in bonds. She’d add more the older she got, deepening her dependency on those reliable payouts as a shield from the more volatile stock market.
But the world has changed, and nothing’s so simple anymore. Slow growth andunprecedented monetary policy have driven bond prices to record highs. In such an era of ultralow interest rates and longer life spans, a one-size-fits-all approach to bond investing just doesn’t cut it.
“Investors should pay special attention to how passive fixed income investments are managed,” says John Smet, a portfolio manager for The Bond Fund of America®. “Bond index funds tend to be more complicated” than their equity counterparts, he adds.
So when considering a passive approach, whether in a 401(k) plan or individual portfolio, consider these three things:
1. Low yields mean a riskier market
After the 2008 financial crisis, the Federal Reserve cut interest rates to near zero and began a series of quantitative easing programs aimed at stimulating the U.S. economy. Central banks around the world followed suit with the same or similar easing measures. While the Fed raised the fed funds target to a range of 0.25% to 0.50% last December, other central banks are currently employing negative interest rate policies. As a result, it’s now more challenging to find value in the bond market.
Today, there’s little room for error for investors and financial advisors. Because bond yields are near record lows, even small changes in prices have a big impact on overall returns. The inverse relationship of price and yield means small price drops are actually magnified when yields are this low.
While any investment decision should account for the potential downside, that’s especially true for retirees, who rely on a steady stream of income from their retirement investments.
2. Active managers have more flexibility
Finding ways to limit losses in retirement leads many people to passive bond funds, which replicate the performance of an index as closely as possible.
This forced replication can limit managers’ ability to change their portfolios to reflect concerns about rising rates, for instance. However, an active manager can draw from a larger universe and adjust by holding fewer rate-sensitive bonds or by buying more bonds with a cushion against a change, such as corporate bonds.
Active managers also tend to base their strategy on deep research rather than focusing primarily on the market’s price movements.
Above all, active managers have more ways to play defense. They don’t have to follow the market fully when it’s going up and – more importantly – they can modify their investment approach when the market falls.
3. Passive bond funds can be hard to monitor
The bond market is vastly more complex than the stock market. It’s fairly easy to replicate the indexes that large-cap equity exchange-traded funds use. There are only 500 companies in the Standard & Poor’s 500 Index (hence the name). If a portfolio manager wants to match the index, he only needs to purchase the right proportion on the open market.
On the flipside, the Barclays U.S. Aggregate Index, one of the most commonly used bond benchmarks, contains about 9,000 different securities. That’s more volume to keep up with, and what’s more, many of those securities are not easily bought or sold.
Investors in such funds may experience a false sense of security, believing that it accurately reflects the market when it might not. Fully understanding exposure depends on fully understanding the investments in a fund.
Neither passive nor active bond strategies, whether in 401(k) plans or individual portfolios, are inherently dangerous or without risk. What makes an investment dangerous is not knowing those risks.
In these tenuous times, retirees and those nearing retirement must understand the makeup of their portfolios and their portfolio manager’s tools for adjusting to market moves, as well as the overall rate environment.