AndreaCoombes

Is it time for 401(k) savers to abandon bond mutual funds?

Many investors hit the “sell” button on bonds in June—but if your focus is on retirement, think through your options before you follow the crowd.

The specter of rising interest rates spooked investors into pulling an estimated $60.5 billion out of bond mutual funds last month—almost a 47% jump from the $41.3 billion withdrawn in October 2008, amid the worst moments of the financial crisis—according to preliminary data from the Investment Company Institute, a mutual-fund trade group and researcher.

Yields on 10-year Treasurys jumped as high as 2.6% in June, from 1.6% in early May, thanks in part to Federal Reserve Chairman Ben Bernanke’s hints about the end of the central bank’s bond-buying program, which has pushed interest rates to record lows in recent years. (Bond prices move inversely to yields.)

Some of the biggest bond funds in the 401(k) universe took hits. Pimco’s Total Return fund PTTAX, -0.19%   plunged more than 5% from May 1 through July 1 (it’s down more than 3% year to date). That fund holds a whopping $79.9 billion worth of 401(k) assets, according to December 2011 data, the most current available, from researcher BrightScope.

Another big 401(k) player, Vanguard’s Total Bond Market Index fund VBMFX, +0.00% dropped about 4% in May and June, and is down more than 2% so far this year. It’s enough to make your average 401(k) investor break out in cold sweats.

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Heres a look at the popular risk-management strategy of hedging.

Here’s your first rule: Don’t panic. Generally, the best advice for people investing for the long haul—and your retirement could well last 30 years—is to pick a suitable asset-allocation strategy, invest in low-cost mutual funds, rebalance regularly and stick with your plan to guard against the all-too-common mistake of buying high and selling low.

Still, following that prudent strategy doesn’t mean you should ignore big-picture trends. Rates have been at extraordinary lows since the 2008 crisis. They really have nowhere to go but up, forcing bond values down.

With individual bonds, investors can hold them until their maturity date to retrieve their principal. But most 401(k) participants have access only to bond mutual funds. As investors flee for the exits, managers may be forced to sell bonds before maturity to honor those redemptions.

Yet, despite the current rate outlook, it doesn’t make sense to exit bonds entirely, experts say. One reason: While interest rates are bound to rise, no one knows when. And it could well be a year or more before the Fed makes a move.

“You’re essentially timing the bond market just like people try to time the stock market and you’ve got the same risk: You could be wrong,” said Thomas Batterman, a principal at Financial Fiduciaries in Wausau, Wis.

And don’t forget why you own bonds: They provide a ballast against stock-market gyrations. “Although one component might come under pressure, it’s the other part of the portfolio that you hope is acting as a buffer. That’s the beauty of a balanced portfolio,” said Catherine Gordon, a principal with the investment strategy group at Vanguard Group.

That said, here are steps 401(k) investors might consider as they eye the bond-market upheaval:

1. Shift to shorter-term bonds

Generally, long-dated bonds suffer the most as interest rates rise.