Should I Put My 401(k) Money Into Bond Funds?

A mutual fund is a collective pool of funds from individual investors that is allocated by a professional money manager. As the name implies, a bond fund invests in bonds, which are essentially "IOUs" issued by various corporations or governments. While all bonds share certain similarities, bonds and bond funds can vary dramatically in their risk and reward profiles. For example, U.S. government bonds, known as Treasuries, are generally lower-paying bonds that carry the safety of a government guarantee. High-yield bonds, also dubbed junk bonds, offer the lure of a higher interest rate but carry commensurate risk. When choosing a bond fund for your 401(k), it's imperative to understand what types of bonds the fund owns.

For a 401(k) investor, the primary benefit of a bond fund is generally compounded interest. Bonds traditionally pay a stated interest rate to investors, and bond funds are required to pass that income through to shareholders, typically on a monthly basis. Since you generally can't access the funds in your 401(k) until you retire, you're likely to reinvest the interest you earn back into additional shares of the fund. In that way, you'll end up compounding your interest, as you earn interest on your reinvested money as well.

Bond funds also provide some degree of safety. They are generally less volatile than stock funds, and they carry the guarantee by the issuer that they will return principal to investors. In some cases, shareholders can also benefit from capital appreciation, as bonds and bond mutual funds tend to rise in value when interest rates fall.

Bond funds carry numerous risks, some of which are not immediately apparent. One of the greatest risks is that market interest rates rise. This will drive the price of a bond fund down. Unlike individual bonds, which come with a maturity date at which time investors are made whole, bond mutual funds don't have a guarantee. If rates remain high after you buy a fund, you may never see the share price recover. Bond funds also carry the risk of default by an issuer, which will similarly damage the share price of the fund. All mutual funds also have annual expenses, used to fund the operations of the fund company, which can reduce investment returns. All of these factors are negatives for using a bond fund in a 401(k), as the purpose of a 401(k) is to accumulate savings to help fund retirement.

When choosing how to allocate your 401(k) money, analyze yourself first. Ask what your investment goals are, and how much risk you can realistically accept. Over the long run, stocks on average provide a higher return than bond funds, but with greater risk. Similarly, bond funds tend to fluctuate in value more than cash or money market funds, but typically pay higher interest. If you have a long time until retirement, you can often afford to take a bit more risk with your investments than if you nearing the end of your career. As long as you understand the risks and rewards of a particular bond fund, you can consider including it in your 401(k) mix.