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Don't Abandon Bonds Just Yet

Scott Holsopple

Whenever there's talk of interest rate increases, conversations about bond values aren't too far behind. With all you've been hearing about bonds in the news recently, now's a great time to review what bonds are, what role they play in 401(k) investing -- and why they should still be a part of your retirement plan.

Simply put, a bond is an agreement. An investor agrees to let the borrower, or issuer, use their capital for a certain period of time, at which point it will be returned. In addition, the person who borrows the money will pay interest at a specified rate. Most investors tend to have access to bond funds as an investment option in their employer-sponsored 401(k) plans, rather than individual bonds.

Bond funds are often used by investors to help diversify a portfolio and reduce its volatility and risk. It is important to note that bond funds aren't risk-free, however. There's a strong correlation between interest rates and bond values: when interest rates rise, bond prices tend to go down. Investors are so hyper-aware of this that bonds sometimes lose or gain value merely in anticipation of interest rate changes. That's not surprising given the ongoing remarks from Federal Reserve Chairman Ben Bernanke regarding the Fed's massive bond-buying program (and the possibility of scaling back the program later this year depending on the U.S. economy).

Still, even though rising rates do negatively affect the price of existing bonds, diversifed bond portfolios can tend to avoid the type of dramatic declines in returns seen in equity markets. Remember, the "worst" years for bond funds are usually much better than the worst years for stock funds. For example, during the 20-year period from 1993 to 2012 the worst one-year return for the Standard & Poor's 500 index was a 37 percent drop, whereas over the same period, the worst one-year return for the Barclays U.S. Aggregate Bond index was a 2.9 percent decline.

So, even though the current environment may be a challenging one for bond investors, bonds still play an important role in a diverse portfolio as a buffer against the volatility of other higher-risk asset classes. Here's what you can do to help make sure your portfolio is well-balanced and on track for the long term:

--If the current market environment is tempting you to jump out of bond funds into higher-performing stock funds, don't alter your long-term investing strategy in the hopes of achieving some short-term gains. Remember that bond funds can help balance your portfolio's overall levels of risk and return.

--Revisit your asset allocation to evaluate whether your current exposure to different types of investments, including bond funds, is appropriate for you. For help determining the right mix of investment types, try an online asset allocation calculator or contact a financial adviser.

--If you've got access to more than one bond fund in your retirement plan, you might consider diversifying your bond holdings. When comparing bond funds, one important aspect to consider is the duration of each, or the measure of how likely each is to react to changes in interest rates. The lower the duration, the lower the effect interest rate changes are expected to have on the fund's value. Morningstar clearly shows each bond fund's average effective duration, if you'd like to compare the average duration of each bond fund in your 401(k) plan.

It's not possible to make accurate predictions of the future. Despite the possibility of higher interest rates down the line, bonds still remain an important part of your overall retirement plan -- especially if you are nearing or in retirement. Bottom line: stick to your long-term investment plan and avoid knee-jerk reactions to market fluctuations.

Scott Holsopple is the president of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal.

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