How bond funds help diversify your 529 portfolio

BOND ARTICLE IMAGE.jpg.pngIf you own a 529 college savings plan account, chances are you have bond funds as underlying investments in your portfolio. Bond funds play a key role in limiting the risk in your portfolio, especially as your child gets closer to college. That's why it's important to understand the types of bond funds included in your 529 plan and the role of these investments in your portfolio.

What are bond funds?

Whether you own an age-based option or individual portfolio in your 529 account, your bond allocation is invested in underlying mutual funds. These mutual funds are diversified—they pool together money from many investors to buy various bonds issued by a variety of institutions. Unlike stock funds, bond funds grow primarily by the income they produce rather than the price they command.

Bond funds are a powerful portfolio diversifier. They help to cushion your portfolio from big swings in the stock markets and can lower your overall risk. Most 529 plan investors dedicate a smaller allocation to bonds when children are younger and investors seek the growth stocks can provide. But as time for college—and the tuition bill—approaches, the allocation can gradually become more conservative. That is, the bond allocation increases, with a goal more toward preserving assets and less toward growing them.

What types of bond funds are in 529 portfolios?

As with stock mutual funds, the holdings in bond funds vary from fund to fund and can include bonds from the U.S. Treasury, U.S. government agencies, state and local governments, and U.S. corporations. Some funds may invest in foreign bonds, and other funds may invest in inflation-protected bonds.

As an example, Vanguard Total Bond Market Index Fund is commonly used as an underlying investment in 529 portfolios and provides broad exposure to U.S. investment-grade bonds. It invests about 30% in corporate bonds and 70% in U.S. government bonds of all maturities—short-, intermediate-, and long-term. It can be considered middle-of-the-road in average maturity and average duration, both of which are typically between 5 and 10 years for this fund. The fund can serve as a good core bond holding.

Two key terms to know about bond funds are maturity and duration. Average maturity is the average length of time until bonds held by a fund reach maturity and are repaid. The longer the average maturity, the more a fund's share price will move up or down in response to changes in interest rates.

Average duration is a measure of the sensitivity of bond (and bond mutual fund) prices to interest rate movements. For example, if a bond has a duration of two years, its price would fall about 2% when interest rates rise one percentage point. On the other hand, the bond's price would rise by about 2% when interest rates fall by one percentage point.

Should I be worried about rising interest rates?

Many bond fund investors are worried that the portion of their portfolio in bond funds will go down when interest rates go up. It's true that bonds can and do drop in value. But, while bond fund prices may drop in the short term, downturns in bonds are generally not as severe as downturns in stocks.

It's important to understand that a rising interest rate environment may not be the traumatic event that many seem to think. In addition to being a hedge against stock market volatility, bond funds are used for income, and rising interest rates mean more income.

Plus, bonds in a mutual fund turn over continually, and portfolio managers reinvest that money in newer bonds with higher interest rates, benefitting investors with increased income.

In addition, the Federal Reserve's plan to gradually raise interest rates has been known for some time and has already been priced into the bond market. So a lot of the noise about the bond market may be just that—noise. And making a change to your portfolio based only on the expected path of the federal funds rate isn't likely to improve your long-term results.

All investing is subject to risk, including possible loss of principal.

Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.

Diversification does not ensure a profit or protect against a loss.