Confused About the Use of Bond ETFs in Target Date Funds instead of Raw Bonds

Question

I’ve been investing in my company’s 401(k) for a while now, and since I didn’t know much about the financial market when I started, I just went with the default option: a target retirement date fund set for 2065.

After doing some research, I’ve grown concerned about the allocation strategy of this target date fund. Right now, it’s mostly in stocks, which I’m okay with. However, it also allocates around 20% to international stocks and some to bonds. As the target date approaches, the fund gradually shifts towards a heavier bond ETF or mutual fund (not actual bonds) allocation, which I’m starting to question. The problem with BND is that it NEVER matures, and can technically go lower and lower. Bonds are fine, but those ETF wrappers look weird to me.

My main concern is the type of bonds in this fund. From what I understand, these are bond ETFs and mutual funds like BND, and I’m really worried about their stability. Bond ETFs have been in a bear market for the last decade, and with the current interest rate environment, they don’t seem like a safe bet to me. I’m concerned that holding bond ETFs is riskier than holding a stable stock allocation, especially since bond ETFs can lose nominal value, unlike cash or individual bonds with a set maturity date.

I understand the rationale behind holding bonds as retirement approaches for stability, but I have a problem with bond ETFs and mutual funds that continuously reinvest and buy bonds, regardless of market conditions. This seems to add unnecessary risk to the portfolio.

Given my situation—I’m 36 years old and have about 30 years until retirement—I’m considering switching my entire allocation to the Russell 1000 Index Fund available in my 401(k). My plan is to let it ride in stocks for now, and maybe start allocating to international stocks in the next decade if they start to perform better. I also think about moving some funds into a money market account closer to retirement, but I can't see a scenario where I would need bond ETFs.

My questions are:

1. What’s the rationale behind including bond ETFs in a target retirement fund? Why would anyone choose bond ETFs over individual bonds with a set maturity date for stability?
2. Does anyone see any potential issues with my plan to allocate 100% of my 401(k) to the Russell 1000 Index Fund?

Answer 1

TL;DR Bond ETFs do go up and down in value, but so do individual bonds; you just don't see that change unless you sell the bond before maturity. Bond ETFs still earn a relatively stable yield (paid out in dividends) regardless of their price change. You only realize a drop in price if you sell the ETF; if you hold the ETF for many years you'll probably ride the ups and down while collecting the income in dividends.

The reason bond ETF prices are lower than they were 4 years ago is because interest rates have gone up - as interest rates go up, the value of existing bonds goes down as explained below. That is reflected in the Bond ETF price, but it also can help as the ETF replenishes bonds that mature with new, higher-yield bond that will go up in value if/when interest rates go back down. You still get "stable" income but also benefit when interest rates go down.

So if you are just holding investments until you retire, then the up and down of bond funds is less important to you than what they pay in dividends (which often gets reinvested into the same fund at lower prices if the ETF price has gone down)

Longer explanation:

Bond ETFs are more a play on interest rates than individual bonds. Yes, if you buy an individual bond your return is fixed (barring default) so it may seem like they do not lose money, but it reality if you hold a bond with a fixed interest rate and rates go up, you have lost money due to opportunity cost since the money you have invested could have bought a higher yield bond.

Say you bought a bond that pays a 3% coupon when government interest rates were at 1% like they were in 2020. Now government rates are at 5% and a bond with comparable risk to your is paying 7%! So while you were guaranteed a 3% return, your bond has lost value because it is worth less now if you were to sell it.

Given my situation—I’m 36 years old and have about 30 years until retirement—I’m considering switching my entire allocation to the Russell 1000 Index Fund available in my 401(k).

That's probably a better play in the long run. You have plenty of years to absorb the ups and down of the equity market and don;t need to worry about "target date" funds for quite a while.