By Jason Zweig | 5:45 pm ET May 31, 2013
Image Credit: Christophe Vorlet
Is the invasion of the “offbeat bond funds” about to reach your 401(k)?
Over the past three years, bond funds that invest outside the mainstream of U.S. Treasurys and investment-grade corporate debt — in high-yield bonds, foreign and emerging-market debt and floating-rate or “bank loan” portfolios — have attracted record quantities of cash from investors desperate for income.
Now they are being marketed in “white papers” and sales calls as the next new thing for 401(k) plans. The offbeat bond funds offer higher income, greater diversification, some protection against rising interest rates and at least the potential for higher returns. But they could add other risks and might bring out the worst behavior in retirement savers, say industry analysts.
“The basic principle that there’s more to the bond market than U.S. Treasurys and corporate issues is correct, but you have to appraise the risk of these funds,” says Laurence Siegel of the Research Foundation of CFA Institute, a nonprofit that studies investments. “And the ones with the best recent performance are most likely to have the greatest risk,” he says, since they are most likely to be overpriced.
You could see a glimmer of that on Wednesday when high-yield, or “junk,” bonds got hit by a selloff over fears that the market had gotten overheated.
I spoke this past week with nearly a dozen executives who run pension or 401(k) plans at U.S. companies. Almost all said they have recently been contacted by asset-management firms asking them to consider adding funkier bond funds to their menu of retirement-fund choices. None have bitten—yet.
“In the low-yield environment we’re in right now, the three things investors need are more income, better diversification and protection from rising rates,” says James So, a product manager at Western Asset Management, a subsidiary of Legg Mason that manages roughly $460 billion. Offbeat bonds, when they aren’t overpriced, offer the potential for all those benefits.
“As a plan sponsor, you should offer opportunities for diversification,” says Michael Rosenberg, a senior vice president at Prudential Investments, which manages approximately $840 billion. “If you don’t have anything that can protect against inflation or rising interest rates, your participants who want to take advantage of those opportunities may be missing out.”
Mr. Rosenberg says demand from retirement plans for Prudential’s high-yield funds is up about 70% this year, and the firm has been seeing “a lot of interest” in adding bank-loan and global-bond funds to 401(k) plans.
One thing these funky bond categories have in common: They often act like stocks, with big ups and downs that could alarm investors used to the more-placid behavior of investment-grade bonds.
In 2009, according to Morningstar, emerging-market-bond funds gained 32%, bank-loan funds 42% and high-yield funds 47%. But those spectacular returns came after catastrophe the year before: In 2008, emerging-market bond funds lost 18%, high-yield funds lost 26% and bank-loan funds fell 30%—even as intermediate U.S. government funds gained 4.8%.
During a recession, when other types of bonds tend to do well, high-yield bonds can suffer, since their issuers can be at risk of default. Bank loans historically have been much less liquid than mainstream bonds. And emerging-market debt is subject to periodic panics. All three offbeat categories have been trading recently near record-high prices, raising the possibility that retirement investors unfamiliar with their risks might buy in just before a fall.
Several studies have found that adding extra investment options to a retirement plan can discourage employees from saving, evidently because the additional choices set off confusion and potential regret.
“If we keep adding all these new options, we might help the participants marginally on diversification,” says Shelly Heier, president of Wurts & Associates, a Seattle-based firm that advises companies on investment strategies within retirement plans. “But if at the same time we discourage them from participating [in the 401(k)], that’s actually a step backwards.”
Another issue: The average 401(k) investor, according to Aon Hewitt, has 68% in stocks and less than 10% in bonds. An investor who put a full fifth of his bond allocation into offbeat-bond funds would have only 2% of total assets there—not much of an improvement in overall diversification.
“People think bonds are safer than stocks and you’re supposed to get your money back,” says Mr. Siegel of the Research Foundation of CFA Institute. “If people lose money in bonds it’s going to hurt.”
If you run a company that sponsors a 401(k), you should resist adding these options unless they can be safely mixed into a broadly diversified fixed-income fund or a “target date” portfolio that bundles many different assets and adjusts their proportions as you age. If you are just a 401(k) saver, take your risks with your stock funds. In your bond funds, always put safety first.
Source: The Wall Street Journal