Warning: How the Bond Bubble Will Secretly Sabotage Your Retirement

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A tool intended to make retirement investing easier may result in many Americans taking an unwitting hit to their portfolios when the bond bubble finally pops.

We're talking about target-date funds, designed to be "set it and forget it"-style retirement vehicles for people who don't want to bother with actively managing a portfolio.

Such funds usually include a combination of stocks and bonds, with the ratio dependent upon the investor's retirement date.

When retirement is 25 years or more in the future, target-date funds typically hold about 90% stocks and only 10% bonds. But as time goes on, target-date funds shift the balance more in favor of bonds, with the intent of reducing exposure to risk and volatility.

By the time retirement is 15 years away, the balance is 75% stocks and 25% bonds. And when that nears to just five years away, bonds generally rise to about 40% of the portfolio.

So as we edge closer and closer to higher interest rates and the negative impact that will have on bonds – the dreaded bond bubble – many workers approaching retirement are slowly adding more and more exposure to it.

What's more, many future retirees may not even know it.

That's because employers often make target-date funds the default in their 401k plans. That's one reason that money invested in target-date funds has doubled just in the past four years to $534.83 billion.

And the true extent of the problem is actually much, much bigger, as many people follow a similar strategy in their 401ks by moving more of their portfolio away from stock mutual funds and into bond funds as they grow older.

"People think this is safe money," Dave Scott, chief investment officer of Sunrise Advisors, told The Wall Street Journal. "Losing money in bonds is a brutal way to lose money."

How the Bond Bubble Will Crush Target-Date Funds

Over the past five years, the U.S. Federal Reserve policies of keeping interest rates near zero while buying hundreds of billions of bonds have been good for bonds in general.

The low rates, which translate to low yields, have kept bond prices high. (Bond prices move in the opposite direction of yields.)

Recently, the Fed has started to drop hints that it's trying to figure out how to change its policies – cut back its bond buying and allow interest rates to start rising – without spooking the stock market and harming the economy.

The timing will depend on how well the Fed thinks the economy is doing, but most economists agree this shift is coming sooner rather than later.

In a Wall Street Journal survey of private economists taken last week, 55% said they believe the Fed will start dialing back its bond purchases before the end of this year. None expected any increases in bond purchases.

But when the Fed finally does start to reverse course, even in a subtle way, bond prices will start to fall.

Few expect the popping of the bond bubble to result in a sudden collapse in the bond market. Instead, it will be more like a balloon with a slow leak – a steady erosion over time.

That erosion will gradually eat away at the bond portions of target-date funds and take ever-bigger bites out of bond funds. Investors who own these funds potentially could lose a major chunk of their nest egg before they even realize what's happening.

"The odds of interest rates going up – just from a common-sense point of view – is very high," Bob Rice, managing partner at Tangent Capital, told The Daily Ticker. "And if that happens many of these bond funds will suffer 20%, 30%, 40% declines in value."

How to Protect Your Retirement Against the Bond Bubble

A significant investment loss just as a person is about to retire would have devastating consequences. It could force a delay in retirement, or worse – cause a retiree to run out of savings before they die.

Investors don't have many options, but Rice suggested the first line of defense is making sure you know how much exposure your retirement portfolio has to the bond bubble.

Those with target-date funds need to find out just how much of their portfolio is in bonds.

Those with bond funds need to find out if the manager has added stocks to the mix as a hedge against the bond bubble. Many bond funds can hold as much as 20% of their portfolios in stocks, but that strategy means an investor could have more exposure to equities than they think they have.

"You have to dig into the paperwork," Rice said.

Alternatives, however, are not easy to come by. Shifting to a portfolio that's 90% stocks isn't a great idea for folks approaching retirement, as it simply exposes investors to the kind of high risk and volatility they were trying to avoid by investing in bond funds.

Michael T. Prus, president of Scale Investment Group LLC, told Fiduciary News that investors anxious about how rising interest rates could hurt their portfolios "should be invested in some combination of short or ultra-short fixed-income and stable value/cash to minimize principal fluctuation to an acceptable amount."

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