Q. I've lost so much money in my stock market funds in my 401(k), so I'm switching to something safer -- a bond fund. Is that a good idea?
A. I've received dozens of e-mails from people seeking safe refuge from the volatility of the stock market by switching to bond funds. What they don't realize is that you can lose just as much money in a bond fund, and just as quickly! Bonds have their own set of risks -- even the bonds in the well-managed fund that has been chosen for your 401(k) plan.
That's not to say you shouldn't diversify your retirement investments into bonds. But you should understand the risks in buying bonds:
Credit risk
Not all bonds are equally "safe." U.S. Treasury bonds have the highest "triple A" rating -- even though our country is deeply in debt! All bonds carry ratings, ranging from AAA down to BBB-minus. Below that level, bonds are considered "non-investment grade." That means there is serious doubt about whether the company will earn enough to pay the interest, or worse, enough to repay the principle when the bonds mature.
A company's financial situation may change quickly -- before even the ratings agencies catch up! General Motors' bonds (and Chrysler's just before the bankruptcy filing) fall into this category. They started out as very good credits -- but as the auto business fell apart, there is little chance there will be enough in assets -- even in bankruptcy -- to pay off their bonds in full. In a bankruptcy proceeding, bondholders stand first in line -- but there may not be enough assets to repay them completely.
The lower the likelihood of repayment, the higher the interest rate that will be offered by a company (or municipality) that desperately needs to borrow money. That's why you should look twice at tempting high-yield bond funds. Moody's, a bond rating agency, estimates that in 2009, a record 14 percent of high-yield bond issuers may default.
If you're going to buy bonds, you should be aware of the credit ratings of the bonds, or bonds in the bond fund -- and understand that the higher yield is a function of higher risk!
Interest rate risk
There is another kind of risk that's inherent when you buy bonds -- even the top-rated bonds. It's called interest rate risk. That's the risk that you'll lock up your money for 10 or 20 years today -- even in a top-rated U.S. Treasury bond -- and then the general level of interest rates will move higher. You'll be stuck with your low-yielding, fixed-rate bond for years. Big mistake.