Question on bond fund

Matt, is a portion of your retirement portfolio by any chance outside the

401(k)? Say, in an IRA?

Are you following the conventional wisdom about how much to put into a

401(k)? Namely, only up to that which your employer matches?

I personally feel interest rates bottomed out a year or so ago. The "conventional wisdom" does not exactly apply in such conditions, and many web sites discuss this. I think rates can only go up, but they'll go up very slowly, and I imagine they'll kind of stop and oscillate around a mean for a few years here or there, too, in the next 15 years. Like you have noticed, as rates rise, NAVs of investment grade (IG) bond funds like yours will go down, and yield rises. Multiplying NAV and yield tends to give a constant product. In a record low interest rate environment, where rates can only rise, one is locking in a low rate of return for as long as one holds the IG bond fund.

If possible, I think the prudent choice is to put at least some of one's IG bond allocation into a bond ladder. Say a five-year ladder, with CDs or IG bonds maturing one-year apart. Hold all to maturity. That way, you capture the rising yield, but lose no principal. Also there are no commissions on CDs; they have nice yields right now; bond funds tend to have expense ratios that really eat into yields; and so a newly begun, five-year bond ladder, having an average maturity of 3 years may very well have a higher yield than a bond fund with an average maturity of 3 years. Compare CD rates at bankrate.com with a fund like FSHBX (ave. maturity = 2.7 years, yield 2.58%), say.

It's not too late to make a change, but nor is there any rush to do so. Interest rates are not going to charge up overnight. That would wreak havoc on the economy, and the Fed et al. know this.

Matt- Some investors (including me) don't bother with anything but short-term bonds in the "standard plan" because we think the additional returns of longer maturities don't compensate you for their risks.

I just checked these a couple days ago, and it illustrates the point - recent corporate bond yields looked like this:

2 yr - 3.90% (AA) 5 yr - 4.40% (AAA) 10 yr - 4.98% (AAA) 20 yr - 5.34% (AAA)

There's quite a flattening out of the yield, even after 2 years. The risk-return tradeoff isn't present here. The 20-year bond buyer is accepting a 5.34% yield for that entire time period, and a lot more risk...for not even an additional 1% of yield over the 5-year bond. Why bother?

This is a point-in-time illustration but the long-term data bear it out as well- there hasn't been much, if any, long-term advantage to longer bond maturities. They're a lot more volatile but don't necessarily return more. Again, looking at long periods of time - there have been exceptions.

I say the "standard plan" because I would reassess this if we could again buy Treasuries yielding, you know, 11% or something like that. And it's tied to individual circumstances...an investor with known cash needs (that can be met with the current yields) might not care about the risks of the longer maturities. But for the typical long-term investor focusing on a fixed asset allocation I think the "stick to short-term bonds" approach deserves consideration.

-Tad

short-term

I think this analysis is too simplistic for investors trying to fund long-term obligations such as a retirement fund. You can search "long term bonds snipped-for-privacy@aol.com" in this newsgroup for a December 30, 2004 message on this topic.

keep investing the same amounts ("stay the course" in that regard).

It sounds like you put 70% into stocks and 30% into bonds. How did you come to this conclusion? If the assumptions made at the time you decided 70-30 was a good mix are still the same, stay the course percentage wise too. If the assumptions changed (you can tolerate more risk) then go up to 80 or 90 percent stock. If the assumptions changed (and you can tolerate LESS risk), then I would suggest reducing equities some and bonds some (maybe 60-20) and put the other 20% into money markets (cash), real estate, materials, or another investment category.

"Tad Borek" wrote

It certainly is. It's arguably just a bad coincidence that the curve is not so steep right now. In fact, the yield curve for one to five year maturities can be quite steep. Why not send this fellow to the fine site I think Rich C. identified to me a year or so ago, showing graphically how the yield curve has changed in the last 25+ years?

I have strong doubts about the statements above. Then again, it may be a matter of risk vs. return tolerance.

I would just like to add the caution that studies on withdrawal rates in retirement for different portfolio allocations (X% in stocks; Y% in bonds) assume the bonds are long-term, high grade corporate bonds.

This gentleman is not in retirement, but he might want to review recommendations on portfolio allocations for his age and expected years to retirement before deciding what maturity bonds to hold.

I liked what people on this group suggested to me a year or so ago: Don't go out more than about five years with individual bond maturities. That's roughly about when the yield curve has started to flatten most.

So did your twin sister Caroline, who wasn't ever convinced either. But I don't think she ever followed the pointer I gave to

which has some pretty convincing data (she did seem to follow the link to the yield curve on SmartMoney). The thread was "Idea short/medium term portfolio" [sic] in early 04.

See, Beliavsky isn't the only one who keeps old posts about bonds. =)

-Tad

I would stick with it. You've pretty much already listed the reasons: as a re-balancer, don't try to time the market. Like you said, you don't know how high to wait for rates to go to jump back in. What if rates stay about the same for the next 5 years? Also, future interest rate increases have already been priced in.

Thanks for the great suggestions and advice. I am looking into the links suggested, and this is very useful information for me.

To answer some of the questions asked, I have been contributing the maximum to a Roth IRA and 401(k) up to the pre-tax maximum allowed, and hope to continue to do the same. The Roth has about 15% of my retirement money with the rest in the 401(k). I have mostly stock funds in the Roth (following the guideline that the Roth should have one's most aggressive investments). I now realize that I have more options in the Roth regarding bond investments.

The 70-30 stock/bond mix is a target I picked based on a questionnaire provided by my employer. My actual allocation is not quite there yet, but I am trying to adjust periodically mainly by re-targetting future investments. My current allocation for retirement money (including

401(k) and Roth) is as follows: Employer stock: 18% (trying to reduce this) Large cap funds: 31% Small cap fund: 6% International fund: 6% Intermediate-term bond fund: 23% TIPS fund: 3% High-yield fund: 3% Money-market: 10% I am a homeowner, which I assume provides enough exposure to the real estate market.

Thanks Matt

questionnaire

It gives you exposure to residential (not commercial) real estate in one location, and even if you intend to tap home equity for living expenses in the future, I am not sure that it should cause you to exclude REITs from your portfolio. The optimal allocation to REITs could depend on the ratio of your house price to the size of your investment portfolio. I think this number is probably higher on average in California than (say) Kansas.

Workers in the private sector have incomes that depend on the general business climate, but the conventional wisdom is that they should have some money in stocks. Actually, I think labor income risk is an important factor that is ignored in most asset allocation studies.

Matt, You may know this but there are two sides to that, when you have company stock in the 401k. You do take on some additional, company-specific, risks with that, especially when it's also your employer.

On the flip side there are tax benefits associated with 401k stock, as long as it goes up in value. You pay a lower tax rate on the gains and may be able to access the stock earlier than the usual age, without much penalty for doing so.

The more it goes up, the greater the tax benefit. So netted out a dollar of gain on those shares is worth more to you than a dollar gain in an S&P 500 stock index fund in your 401k. This could lean towards a higher allocation if you think in "after tax" terms. It really depends on your confidence in the company of course.

The tax part of this is NOT an easy topic but for more info talk to an accountant or google: NUA 401k. The key term is "NUA", Net Unrealized Appreciation in your employer stock - that's given the special tax treatment.

Last point - to the extent you do leave dollars in your employer stock you might consider weighting the rest of your retirement portfolio accordingly, to tug it in another direction. Meaning, lighten up on stocks whose performance are expected to be correlated to the stock of your company. That's not always possible but between an IRA and 401k you can often do something. In some cases it's easier...if you work for a company like Intel for example you can readily identify the sector and you know your company is a major component of that sector.

-Tad

Tad,

Do the NUA rules apply to company stock that was actively purchased, or just to company stock that was used to match contributions?

Thanks,

-Will

Will, NUA treatment applies to employer stock held in a qualified plan. There are a few different ways it could end up there, the key is that it's held in the plan. The benefit is the biggest when your original cost is low because only the cost basis is subject to ordinary income tax rates (and the 10% penalty if you're taking the stock out of the plan early).

The FPA's journal had a pretty good article on the topic last year:

-Tad