Protect 401(k) From Stock Crash With Investment Grade Bonds

Examine your 401k holdings to see if they are investment grade bonds. The way to do this is to first find the five digit ticker symbol for the mutual fund choices for bond mutual funds offered in the 401k. Then Google the individual bond mutual funds and find out the name of the mutual fund family and go to the fund family’s website, then go to the web page for that particular bond mutual fund. The mutual fund company’s website should say what percentage of the fund’s holdings are in a certain credit grade and possibly give a weighted average of the total holdings. Unfortunately Pimco (a large bond mutual fund family) stopped offering this information in writing although they have given it me orally. It makes me wonder: why are they afraid to put it in writing?

Understanding letter grades for credit quality

For S&P or Fitch: grades AAA to BBB- are investment grade. Grades BB down to D are below investment grade. For Moody’s they use Aaa to Baa3 for investment grade and Ba1 to C for below investment grade. The rating agencies use “NR” for not rated. This could be a problem in cases where a large percentage of bonds in a mutual fund are “NR” then an investor doesn’t know what he is getting. See Wikipedia. Large, well established companies tend to get rated and smaller ones may not, so just because they are not rated doesn’t mean they are bad, but I would feel better buying funds that have a minimal percentage of NR rated bonds. However, the fund companies claim they can evaluate the credit risk of NR bonds.

The problem with grades is that they are based on the past; there is the risk that new circumstances could erode a company’s credit quality. The mutual fund company attempts to look out for the risk of credit quality downgrades before they happen but there is no guarantee that they will outsmart the market.

Other sources of bond ratings are Morningstar or other stock reporting services may publish a credit rating for a company, but this is not the same as a bond because each corporate bond has unique terms such as collateral or covenants to maintain certain financial standards. Large companies may have issued many different bonds under different covenants that could make the credit quality different from other bonds issued by the same company, so you can’t simply use a company-wide credit rating to assess the credit quality of a company’s bond.

The danger of blended credit quality in bond mutual funds

Bond mutual funds need to boost their yield so as to attract investors. They do this by buying junk bonds and diluting the portfolio with a mixture of 19.9% junk (below investment grade) bonds and 80.1% investment grade bonds. Then they offer the mutual fund as an investment grade bond fund. If you insist on buying mutual funds without using an independent financial advisor then you risk being fooled by the mutual funds. One strategy is to carefully read the fund company literature to see if they offer a commitment to very minimal holding of junk bonds. However, in today’s market it may be necessary for investors to take some chances with a small dose of junk bonds inside of a mutual fund that is primarily holding investment grade bonds. The way I evaluate that risk is to examine the corporate culture and essays of the mutual fund and see if they care about credit quality in an overall holistic sense or are they simply ruthless mercenaries trying to be a yield hog who seeks the highest yield regardless of risk.

There is the risk of a new recession later this year and that might result in lots of bankruptcies and short payoffs which would reduce the value of junk bonds. Investors should resist the siren songs of high yield junk bonds that could damage their portfolio. Instead investors should accept the reality of low yielding investment grade bonds with a goal of preserving capital until a huge stock market crash allows investors to buy stocks at good, low, fair prices, at which time one can bid farewell to the bond market.

About the author

Don Martin, CFP®

Leave a Reply

Copyright 2014   About Us   Contact Us   Our Advisors       Login