Bond allocations, long a staple of diversified portfolios, have recently become controversial.
Industry insiders argue that bonds are now a source of return-free risk. A quick Google search for “Why own bonds?” or “Why own bonds now?” reveals thousands of articles. And an army of analysts watch each meeting of the Federal Reserve, waiting (still!) for a change in interest rate policy. With so many so concerned, it makes sense to ask “why does Financial Engines allocate assets in my portfolio to bond funds?”
One part of the answer is that Financial Engines tries to use financial markets — not time them.
This is a key pillar of our investment approach, and has informed our portfolios since we began advising clients. Bonds make up over 40% of financial markets world-wide. Avoiding, or even under-weighting, bond allocations would be a massive exercise in market timing for our members. Predicting interest rates — and bond prices — is notoriously difficult. Second-guessing these predictions to time the bond market may best be left to hedge funds and investment banks. We believe that retirement investors are better served by a more deliberate approach.
We have always thought that bonds and bond funds have desirable properties that make them excellent components of retirement portfolios.
- They have historically delivered higher expected returns than cash.
- They typically exhibit lower expected risk than stocks.
A more subtle benefit can be found in the low correlations of bonds to stocks.
Bonds can often provide the “zig” to stock’s “zag.” For example, just after the mortgage crisis hit, for the year 2008, the Barclays Aggregate Index (a measure of U.S. bond performance) returned 5.24%. Stocks, as represented by the S&P 500, suffered a decline of 37%. Certainly, historical performance is no indicator of future results, and investors should not expect such divergent returns every year. But including investments with low correlations may help investors achieve efficient portfolios with more consistent compound returns.
Current critics of bond allocations often highlight “interest rate risk.”
If the Federal Reserve raises short-term rates, some argue, bond prices (and returns) will suffer greatly. While this may be true for some bonds, it is important to remember that not all bonds are the same. Short- and intermediate-term bonds tend to present relatively modest interest rate risk. In fact, to the extent that market participants expect an interest rate change, those expectations may already be reflected in bond prices. As a result, the types of bond funds typically found in 401(k) plans — diversified, short- or intermediate-term “core” funds — will often bear far less risk than bond critics fear.
Investors, like bonds, have divergent characteristics. For one group of retirement investors – those seeking steady income in retirement — bond allocations may be especially attractive. Investors in Financial Engines’ Income+ program are looking for steady, sustainable payouts from their 401(k) accounts. Our approach to this goal is to allocate 80% or more of the portfolio to bonds. While the portfolio value may go up or down, this allocation should allow the investor to realize a retirement paycheck that is designed to be steady or increasing throughout retirement.
We’re here to help.
Whether you are retired and seeking steady income, or early in your career and looking for an appropriate diversified portfolio, some bond exposure is likely to be right for you. If you are eligible for services from Financial Engines and interested in learning more about how your portfolio is invested, consider having us perform a Retirement Check-up.