Near Retirement? Time to Rethink Your Core Bond Fund
Separate Treasury and corporate bond funds prepare you for market downturns
The core bond fund that likely has been the workhorse in your 401(k)s and IRAs is not ideal once you retire.
Core bond funds and exchange traded funds (ETF) own a mix of U.S. government and corporate bonds. They typically hew closely to the Bloomberg Barclays U.S. Core Aggregate Index, or a similar high-quality U.S. bond index.
To be clear, when you’re saving for retirement, there is absolutely nothing wrong with tucking your bond allocation into a core bond fund. And that’s clearly the go-to move for investors. According to Morningstar Direct, at the end of August there was more than $1.1 trillion invested in core bond funds. Another $800 billion was invested in “core plus” funds that have a slightly longer leash to deviate from what the benchmark index owns.
But once you start making withdrawals from your retirement accounts, there is an argument for shifting all your bonds into U.S. Treasuries, which provide the best protection when the stock market is falling.
Or, if you are eager to continue to own high grade corporates as well as Treasuries (over the long-term, corporates do indeed return more than Treasuries), you might want to consider skipping the one-stop core bond approach and build a two-fund approach with some money in a corporate bond fund and some money in a Treasury fund.
Why? It comes down to what happens when stocks are falling. You’ve no doubt heard (and experienced) over the years that bonds are the “ballast” that holds up when stocks are falling. Indeed, all high-grade (not junk) bonds do better than stocks during bear markets. But that is not to say that all bond funds do well. In the heat of a stock market meltdown, Treasuries, the debt issued by the U.S. government, are typically the best place to be.
Consider what happened when the S&P 500 stock index fell nearly 35% this past February and March as investors reacted to the economic shock of the coronavirus. The Vanguard Intermediate-Term Corporate bond fund, which owns high quality corporate bonds — not junk — fell 11%. The Vanguard Intermediate-Term Treasury fund gained nearly 4.7%. The largest core bond fund, the Vanguard Total Bond Market Index, lost 1%.
That’s not a knock on owning a mix of different types of bonds. Over the long term, high quality corporate bonds produce better returns. Over the past decade (through early October) the 65% gain for the intermediate-term Vanguard corporate fund was nearly double the 34% gain for the intermediate Treasury fund. And the Vanguard core “total” bond fund gained 41%.
But when you’re retired, what you always-always-always want to avoid is needing to pull money out of an investment when it has lost value. If you own a core bond fund that mixes corporates with government bonds, that might not be possible. About 25% to 30% of the average core bond fund is invested in corporate bonds these days.
If you instead keep a chunk of your bond holdings in a Treasury-only fund, and another chunk in a corporate fund, you have more control over where you take your money from. When stocks are falling, your Treasury bonds will likely be doing just fine, and you can use them for withdrawals. Over the longer term, if your corporate bond fund produces stronger returns, you can take withdrawals from there, when corporates are on a roll, or move some of your gains into your Treasury portfolio. As long as the funds are in 401(k) or IRA accounts, there’s no tax bill when you rebalance (move) money from one fund to another.
If you do want to keep some of your money in corporate bonds, it’s important to know that the corporate bond market is not as high-quality as it once was.
A quick tour through bond quality: The ability of the issuer to repay all the borrowed money plus interest is reflected in a bond’s credit ratings. Issuers considered “high quality” can have a rating that ranges from the AAA (the best) to AA, to A, to BBB. That “Triple B” rating is the lowest rung in bond ratings before you slip into junk ratings. To be clear, junk bonds (also called high yield bonds) are the worst type of bond to own in retirement. They behave more like stocks, not bonds. In the February to March slide, junk bond funds lost more than 20%.
Since the financial crisis, there has been an explosion in new corporate bonds, and much of it has been BBB-rated. About half of the high-grade corporate bond market today is rated BBB. That means about half of the corporate bonds you own in a core bond fund are BBB as well. For the record, U.S. Treasury bonds are rated AAA.
To be clear, you don’t have to worry about defaults. Triple B is still high quality, just the lowest high quality. The issue is that the more BBB-rated bonds you own, the bumpier the ride will be when stocks falter. Having a separate stash of Treasuries will deliver two payoffs. As noted earlier, Treasuries typically rise in value when stocks fall; that will help your overall portfolio performance. And if you need to make a withdrawal when stocks are down — for a required minimum distribution or to cover living expenses — you don’t have to touch other bond holdings that may experience losses in the heat of a stock bear market.