Q: As I approach retirement in 2-3 years, I understand that it would be wise to reduce the volatility of my investments and become more conservative. Generally I would expect that to mean putting more of my investments in bonds and fewer in stocks. But I also hear warnings about the impending rise in interest rates that could reduce the value and yield of bonds. From your perspective, what are the pros and cons of bond mutual funds, and what would be an appropriate percentage of my investments dedicated to bonds?

A: You should have an overall investment plan. And that investment plan should be based in part on your retirement planning which should help you to determine the level of risk you need to take and are comfortable taking.

Generally speaking, someone within a few years of retirement would have a balanced portfolio of stocks and bonds. A 60-year old, for example, would generally have a portfolio about evenly divided between stocks and bonds. If you desire somewhat higher long-term returns and are comfortable taking a bit more risk, you tilt your holdings more towards stocks (e.g. 60 percent stocks, 40 percent bonds). Conversely, if you don't need as high a return and get queasy with the stock market's gyrations, you'd go with a lower stock allocation (40 percent) and higher bond allocation (60 percent).

As you approach and enter retirement, you should gradually scale back the risk (stock portion) of your portfolio through periodic rebalancing.

You are correct that there has been lots of discussion and concern about higher interest rates in the future. Rising rates would decrease the value of all bonds, whether they are held individually or through a mutual fund. However, you are incorrect when you say that rising rates would reduce the yield of bonds. When rates rise, existing bond prices fall so that the effective yield on those bonds increases to match the interest rate (yield) on newly issued bonds.

Below is a chart of the yield on AAA-rate corporate bonds dating back more than 90 years. As you can see, there have been many short-term periods of rising rates but the last prolonged period of rising rates was from the mid-1960s through the early 1980s.
 




As for investing in individual bonds versus bond funds, please see the article, "When Investing in Bonds, Should You Use Bond Funds or Individual Bonds?"

Sharply rising interest rates would most likely occur due to unexpected inflation. In that case, Treasury inflation-protected securities (TIPS), would be a bond option for you to consider. See my recent article, "Investors Fleeing to Treasuries Often Don't Understand Their Options."

Another way to protect yourself is to invest with bond fund managers like Bill Gross with a demonstrated long-term track record of success. Please also see other recommended bond funds in the "Preferred Portfolios and Investments" section of this site.



 

Copyright Eric Tyson, 2008 - 2010 all rights reserved.

Eric Tyson is the only best-selling personal finance author who has an extensive background as an hourly-based financial advisor and who does not accept speaking fees, endorsement deals or fees of any type from companies in the financial services industry or product or service providers recommended in his articles, books and his publications.