With interest rates so low, it might be tempting to think bonds are a bad investment. If you are counting on your portfolio to provide reliable income in retirement, however, this might be a dangerous idea on which to act.

Bonds are more than just interest generators and have value beyond the cash payments they spin off.
They provide an important hedge against the risk of loss elsewhere in your portfolio.

Unless there are exceptional circumstances – you plan to withdraw and spend your entire Thrift Savings Plan balance within the next couple of years, for example – you should hold bonds in your investment portfolio all the time.

In the TSP, the F Fund is the only bond investment available. It tracks the performance of a broad sample of the U.S. domestic bond market, as represented by the Barclays Capital U.S. Aggregate Bond Index. This index consists of high-quality fixed-income securities with maturities of more than one year. It includes Treasury and agency bonds, asset-backed securities, and corporate and noncorporate bonds. At last count Dec. 31, the index included more than 8,000 notes and bonds. About 40 percent of these bonds were backed by the federal government. The remainder were guaranteed by corporations – with either assets or revenue. The average duration of the bonds in the index was about 4½ years.

The F Fund’s average yield – the interest rate being paid out – was recently about 3.25 percent per year. The F Fund’s share price reflects the market value of the underlying bonds in the index, along with the accumulated interest income, which is reinvested in bonds as it is received by the fund.

The return generated from the F Fund can be broken down into two component sources: the income from interest paid by the underlying bonds, and the change in the market value of those bonds between the time you buy the fund and the day you measure the return.

To understand how the F Fund’s returns are generated, you need to understand how a bond’s return is generated. Consider this example:

You buy a bond for $1,000, collect $50 in interest payments and then sell the bond to another investor for $1,050, a total gain of $100, or 10 percent. You might ask why the value of the bond went up between when it was purchased and when it was sold. The reason must be a decline in the interest rates for similar bonds. Since the interest rate paid on a bond is a fixed dollar amount, rather than a percentage, the price of the bond is adjusted up or down in the market until that payment is in equilibrium with the prevailing rate. When the bond was purchased for $1,000, that $50 interest payment represented a 5 percent rate of return. When it was sold for $1,050, that same $50 interest payment represented a return of only 4.76 percent. Why would you sell a 5 percent bond in a 4.76 percent market? You wouldn’t, so you raise the price to adjust the return for the buyer.

This price adjustment works both ways. If interest rates rise between when you buy a bond and when you sell it, the price you can get for the bond will fall. Like the bonds it represents, the F Fund’s share value can also risk and fall in reaction to interest rates. This is behind the recommendations to avoid bonds. In today’s low interest rate environment, many investors believe interest rates have nowhere to go but up in the future, and in turn, bond values have nowhere to go but down.

The problem with abandoning bonds is that they tend to produce a hedge against short-term stock price volatility. When the market price for stocks falls, investors tend to take their money from stocks and invest it in bonds – particularly government bonds – bidding up the prices and lowering interest rates. This offers investors who favor predictability important protection against losses. While it might seem attractive to avoid the risk of loss from bonds and rising interest rates, this must be balanced against the corresponding increase in risk from losses in stocks, which tend to be more severe. When all of the risks, including the risk of being wrong about interest rates, are taken into account, it’s hard to make a rational case for abandoning bonds in your portfolio, or F Fund shares from your TSP account. A more reasonable approach is to be vigilant in making sure your allocation to the F Fund is not significantly overweight relative to its target. This is accomplished by rebalancing your account at least once per year, but no more than four times per year.

Written by Mike Miles
For the Federal Times

Publication April 29, 2013