"All money in bonds strategy" 
or TIPS will never fail you

1. Introduction
2. Popular 401K investors delusions
3. Fashionable mutual funds mix
4. Follow the leader
5. Naive Siegelism
6. "Financial alchemist" strategy
7. Stable value only or "Depression might start tomorrow" strategy.
8. Bonds-based strategy
9. "Gold always shines bright"  and "Commodities rulez" strategies
10. Lifecycle strategies
11. Economic cycle based market timing
12. Combination of lifetime strategies with market timing.
13. Conclusions
14. Webliography
15. Old News

Introduction

Holding individual T-Notes/Bonds is never a bad idea. As long as they're held to maturity, they can't "fall in value." You'll get 100% of your investment back. Holding T-Note/Bond mutual funds is another matter entirely, since whenever you need that money it could be worth less than what you paid in, much less.

Bond interest can be separated into two part. One part is inflation based and the second is "real yield". Actually there are bonds called TIPS which are structured exactly as described.  As of 2013 The Fed is targeting 2% inflation. The long-term spread between 10-year Treasuries and CPI is about 2.5% (the "real rate"). That gives 4.5% as a probable target for the 10-year bond.

But typically 401K investor can't invest in individual bonds and has access to limited number of bond funds, typically two or three (all the rest in a typical 401K plan are stock funds).

The main advantage of bond funds is that they provide steady return despite (sometimes wild, like in September-October 2008) fluctuations of bonds fund share values.  But it is important to understand that bond funds create what can be called "indefinite maturity bond with limited duration".  So they behave differently then individual bonds.

While duration of bonds in a bond fund if usually defined by prospectus, this artificial bond (which is a package of bonds) never mature. So in raising rate environment you might not  get your principal back in the bond duration period. And principal fluctuations can be substantial. If duration of bonds in your bond is 10 years then 2% change of interest rate lead to 20% oscillations of the price of the bond fund. 

It goes without saying that all bonds with duration over 10 years are essentially government bonds. And that applies first of to mortgage backed bonds. That are very few idiots that can lend their money for 30 years at 4% or less ;-)

There are several major lessons of this discussion for individual investor:

• Bonds funds are more complex instrument that individual bonds and selling them is possible only during rather short "window of opportunity" moments. Buffet saying "my favorite holding period is forever" is fully applicable to bond funds.
• Generally one should avoid bond funds with duration over 10 years.  Over periods longer then 10 years inflation and other critical factors such as political stability of the nation are completely unpredictable. You better be safe then sorry.
• Corporate bonds are still risky, but corporate bonds funds that curry multiple high grade corporate bonds probably are not much riskier than TIPS. They usually have shorter duration too, which is a definite advantage.

 Still bond fund provide usually provide more or less uniform average duration of the bonds and quality of the issuers.

Those two variable help to predicts possible fluctuations. And if you keep bond fund long enough to exceed average maturity usually you you principal plus interest paid is at least equal the amount you invested in most (but not all) cases. One important exception are junk bonds which behave more like stocks. 

According to Vanguard approximately 13% of participants in 401K plan had their entire accounts in fixed-income securities. That 's probably the most reasonable part of 401K crowd. Most knowledgeable part of this "bond oriented" crowd use stable value and TIPS for major ("safe") part of   401K portfolio.

A typical bond investor usually do not believe in investment advisor hype and take the investment risk extremely seriously as they should.  The game of 401K investing is first of all about preserving capital, not so much about meaningful return.

Who cares about 10% annual returns of your portfolio in 2004-2007 if you lost 40-50% in 2008 and in desperation sold part of your holdings close to lower point. That's a typical story of "stocks for a long run" 401K investor, probably the most fleeced part of 401K crowd (although compulsive flippers -- speculators who trade their assets too often might come close)

The most important advice here: do not play with your retirement money by increasing the risk.

• "High risk tolerance" is just another, more politically correct, definition of greed and it is usually punishable...  If economics grows 3% a year or less, any return in excess of that carry level of additional risk that might not justify the difference. 
• There is already enough risk in the system even without your allocation decisions (government essentially offloaded all the responsibility on the shoulders of 401K investors; fiat currency risk now is another one that needs to be considered seriously).  
• Any increase of risk such as buying stocks does not necessary increase return as investors in S&P500 had found out in 2008 (as of May 2009 they lost approximately 50% in 10 years in comparison with short term bond holders). In crisis all correlation are one, so divirsication fails you when it is needed most. But taking additional risk will definitely enrich financial intermediaries so they would fiercely advocate for it (look at Vanguard propaganda, and Vanguard is actually is one of best and the most honest broker in this shady crowd).

There are nominal returns lower which bonds became way too risky. For 10 years such return is around 4%.  If return falls below then you generally should think about shortening the duration of your bond portfolio.

The key idea here is to understand that a safer strategy might be to use type of allocations: stable value or short term TIPS for part of your portfolio that you will need before  reaching the age of 70 (the time when people with substantial 401K holding should tap their SS benefits, as they are maximum at this age) and the other part which can be corporate bonds.

TIPS suffer from the fact that the inflation measurement are highly political and as such are crooked but still return around 3% per year even in deflationary environment of 2008-2013.   Inflation is being measured and reported by the US government, which has an very strong incentive to underreport inflation. That why Boskin Commission  changes in CPI, probably were the most intellectually dishonest analysis of Inflation as has ever been penned. The goal of  fraud perpetrated by Boskin Commission was to reduce Social Security payments and avoid bankrupting the US Treasury -- not measure inflation accurately. Since then, the spread between the core and headline data have only grown further apart (The Big Picture)

Whenever I hear the phrase "excluding volatile food and energy" I just laugh. Can a pricing group be considered volatile if it merely goes up each month in an orderly fashion -- for years and years?

That's not volatility, thats a trend.

One way to actually measure how absurd the US core inflation measure is to look at what has happened to the spread between headline CPI and Core CPI. If Core CPI is understating inflation, than the spread should be widening. If it is accurate, the overall ratio between the two should be relatively steady.

What does the data show? The spread has increased substantially since the US adopted an ultra low rate/easy money policy under Greenspan (now affiliated with bond giant PIMCO). Since the easy money policy of the 1990s, and the  rate slashing of the 2000s, it is no coincidence that the spread between the headline number and the core has grown dramatically.

If you want to trace this widening spread back to its origins, it coincides with implementation of Boskin Commission changes in CPI. (About as intellectually dishonest analysis of Inflation as has ever been penned -- its goal was to reduce Social Security payments and avoid bankrupting the US Treasury -- not measure inflation accurately). Since then, the spread between the core and headline data have only grown further apart.

This simply reflects the government's BLS inflation data diverging from reality.

Core CPI flatlined over the past 8 years because that is how it was constructed -- to not show inflation. However, the absurdity of the adjustments in inflation measures is revealed in the widening spread between Core and Headline

As one of the key crooks in Bush administration (Greg Mankiw, chairman of George W. Bush’s Council of Economic Advisers from 2001-2003) openly stated “The debate about the CPI was really a political debate about how, and by how much, to cut real entitlements.”

So TIPS are screwed and should be used in moderation and can and should be traded.  Still government has the lowest default risk. And the only realistic alternative to TIPS is gold which is also manipulated by massive scale and might cost you pretty penny if you buy it in a bubble.  That does not mean that you should not buy gold, jus that you need to understand that it also carry implicit mispricing risk. 

Moreover, if you are a baby-boomer you already was ripped off royally by forced switching from defined benefit plans to defined contribution plans.  To a certain extend you already lost significant part of nest egg: it was confiscated by Greenspan-Rubin-Gramm gang of "free market" for middle class, socialism for rich.  In blog entry The Secret to Investment Longevity?  Yyves Smith  noted:

The Wall Street Journal's daily human interest story featured a holiday season tale of the Fuggerei, a Roman Catholic housing compound for the poor in Germany. The price of admission for those lucky enough to get in is yearly rent of one Rhein guilder, which equals 88 euro cents or $1.23, plus daily prayers for the founder, Jakob Fugger and his descendants.

How does such a marvel exist? The settlement is funded by a charitable trust, and the rent remains unchanged since the trust was established...in 1520.

Think about that. Can you think of another pool of capital that has lasted that long, let alone a commercial enterprise? The Fugger family is still well off, but nowhere near as rich as in Jakob Fugger's day.

The story does not give much detail about how the trust survived (a few nasty events like the German hyperinflation and World War II intervened), and gives a few tidbits about the last 200 or so years.

The core holding is forestry properties, which is both a renewable resource and inflation-hedged (admittedly with some volatility) and also owns some local real estate. The article does not indicate whether it holds securities.

Annual returns have been 0.5% to 2.0% over inflation

A fund manager who has quite a successful track record and manages money for families once told me that most investors fail to understand the importance of preserving capital and the value of keeping inflation. He said if you could consistently beat inflation by 2 or 3 percent, you would do far better than most understand. But too many investors chase greater returns, take on undue risk and in the long haul wind up worse off than if they had set more modest and attainable objectives (and note that this manager does seek and generally achieves higher returns because that is what customers want).

There is a second, behavioral issue with seeking higher returns and accepting the attendant risks. Let's say you do have a good year, or perhaps even a run of good years. You come to perceive this level of returns as sustainable, when it may be luck or an unusual set of investment conditions that will not persist. But human nature being what it is, most people would increase their expenditures in line with their new level of wealth, and are ill prepared for a reversal of fortune, as the last year has shown. 

Unless you are very well-to-do there is no such things as safe investing in stocks, especially this absurd idea of "stocks for a long run" (Naive Siegelism). In no way risks of stocks go away with the long run. That's a fallacy. While this is promoted in most so called investor education materials, this is a typical hogwash promoted by financial industry.  If you buy stock you never should not be a static investor (as in "stocks for a long run"). You need to become a trader (you time horizon can be much larger then regular trader but still you need to became a trader). Again, repeat after me, the idea that investing in stock as safe investment for 401K portfolio is a hogwash. You might be better off buying gold because it contradicts the fundamental of economics and first of all the notion of risk premium. The notion of risk premium discredit any muttering by people like Jeremy Siegel that you can avoid risk by taking longer time horizon.  You can only diminish it by selling stocks at higher then average valuations e.g. trading (if, and only if,  such a period occurs during the period you are holding them). So getting oversize returns from stock means successful trading. That's it.  That means that on any fixed target date there in no certainty as for what your value of your stocks portfolio. And never will.

The current situation is a convincing proof that you should not rely on stocks in 'safe" part of your 401K portfolio.  Hedging of risk is more important then diversification for most 401K investors. And the simplest way to decrease your risk is to invest larger part of your portfolio in safe assets. The fundamental idea of risk reward is how much you should allocate to safe assets not those stupid games with various stock funds allocation that are promoted in literature.  You need to think about the entity that guarantee you against default risk. Right now this is money market funds (government will seldom allow them to go down, at least this was proved in 2008) and Treasuries. And anybody who try to persuade you that this is not true is either a shill of some investment company (Siegel's of the world, see Naive Siegelism ) or complete idiots (rarely it can be both ;-). 

In retirement, if you have enough savings and can live simply on interest in tough times fluctuations of bond prices don't matter. What matters is the risk of default. So here you can also use 100-your age formula and diminish percentage of corporate bonds and increase percentage of TIPS with the age. But you need to be careful what you wish for. During normal periods TIPS are competitive with corporate bonds. When they are not competitive (for example in November 2008), the risk for corporate defaults is very high and most of  S&P500 companies bonds are essentially junk as it is unclear which company will survive another year or two. Instead you might create in years close to retirement a stable value (cash) portion of  your principal enough for, say, one or two years as TIPS can fluctuate wildly as we saw in 2008. This way you can avoid selling TIPS when their face value fall too low. 

Another important augment in favor of TIPS is that according to Grantham model long term stock returns are inflation plus 2%. That means that they are equal to average return of 10 year treasures with a fraction of risk.

Please note that the price at which you buy matters. It is actually matter most. Medium and long term bonds including TIPS bought with yields below 5% can be as risky as stocks and single point ("all-in") purchases in such circumstances would better be avoided.  In such cases money market funds or shot term corporate bonds are preferable to bonds as yields are lower but the risk is completely different as recent event had shown us quite well.  In any case it is wise to buy bonds only on dips.  You can then cost average them during as long period as you wish buying some amount each two weeks a month or  even a quarter.

Junk bonds is entirely different category as they behave more like stocks not like bonds. In small dozes (let's say 5% - 10%) they can increase 10 years returns with only minimal increase of risk. But question remains open whether one can use them in (100-your age, see Lifecycle strategies) strategy as a substitution for stocks. It depends whether those companies die like fly on the frost;  2009 was lucky year for junk, but 2027 or whenever the next financial crisis strikes might be less so... .   

The problem with diversified bond fund like PIMCO Total return or Vanguard intermediate fund is that they can drop dramatically in case of real crisis when bonds and stock sink synchronously while in normal circumstances decline n stock usually lead to rally in bonds. That is a sad fact that many people, including myself discovered in 2008.  But for 10 years or longer holding periods they still might be OK and provide slightly higher return then stable value. At the same time you need to understand that  bonds funds are very different from bonds and can be very risky during crisis period. For example LQD dropped from $105 to $80 in 2008. With such drop you can recover the value on your investment approximately in 5 years.   So some caution is appropriate:

• Never buy any bonds funds with average duration close to 10 years and return less then 2% above the inflation.  It is preferable to buy them as points when returns are closer to 6% to have some cushion against decline. Stay with stable value during periods or short duration corporate bond funds. Stay in cash if your 401K plan does not have such finds.  The worst mistake 401K investor can do is to move his finds from stable value into bonds funds when return in stable value dry out. This is a mistake equivalent to buying stocks at the top.
   

• Be vary of buying bond founds which charge big fees.  For example I would prefer Vanguard intermediate to Pimco Total return, if both are available. Pimco average returns are not that different from Vanguard fund, but to earn the same return they need to take more risk and if government would not bail out Funny-Freddie Total Return might has to be renamed PIMCO Total Loss. It's nearly impossible to outperform bond fund (or EFT) with substantially lesser fees without taking more risk and people use bonds funds to cut risk not to enhance it.  In comparison with stable value you can also pay for the errors of bond fund managers. So PIMCO guys should be used with caution or just for trading. Waggoner analysis had shown that the average bond fund with high fees can't beat T-bills over a decade (some charged 1.77% a year in fees, vs. 1.40% for the average domestic stock fund which is a highway robbery to say politely). 
   

• Try to shelter gains from taxes. That's given for 401K investors.  If you buy bonds outside 401K plan you can buy municipal bonds which are exempted from federal tax.  TIPs are also tax exempt  which is not a bad thing. It you paid taxes on capital gains and dividends on a fund that has 1% average annual interest and 1% capital gains that disappeared because fund price dropped, your gains could evaporate .
   

• Rebalance only on high deviations (arbitrage), but do not trade bond funds frequently even if your 401K plan does not penalize for it.  The simplest rebalancing strategy is to wait for the difference between value of simulated contributions to stable value and chosen bond fund (from a given, realistic for you date) exceed one standard deviation up or two standard deviations ( here difference is calculated as  (a-b)/total_contrib ) where:

  • a -- total simulated value of stable value fund using cost averaging from your starting date

  • b -- total simulated value of selected bond fund using cost averaging from the same starting date

  • total_contrib -- total amount you contributed via cost averaging from your starting date.
     

• Keep some percentage of your holding in cash as it helps to protect you from the downside risk. For those people who like me are overly concerned with the downside risk changing percentage from offensive to defensive (for example from high yield/stable value ration of 40:60 to 20:80) might be a better strategy.  Of cause timing will be wrong and usually you will move funds year or even two early, but still you can get some part of "good time" stocks returns.  The signal is widely available. For example in late 2007 almost everybody recommended  boosting their cash allocations and many investment advisors increase cash/stable value portion of the portfolio.  As Emil Lee wrote in his article Protect Your Portfolio! August 16, 2007

  According to The New York Times, Baupost Group's Seth Klarman, regarded as one of the world's savviest investment managers, last year allocated a whopping 49.8% of the group's portfolio to cash, up from 45.8% a year earlier.

  FPA Capital Fund, run by the legendary Robert Rodriguez, currently has a 40% allocation to cash and cash equivalents, and Fairholme Fund, my personal favorite mutual fund, allocates about 20% to cash. If those heavy-hitters like cash, it might be a good idea to give this patient approach a long, hard look.

• Rotate your holdings based on perceived risk. There is nothing wrong to have 80% in cash if the situation is scary. Usually noise about the recession is loud long before the recession started and you have at least one year lead time for reallocation. After reading well-written and pretty convincing paper about recession coming the next quarter or two you can start moving and usually can proceed slowly in small chunks as  bears are almost always notoriously early (and in an interesting way, this fact confirms that is it very difficult to time the market):
   
  • They started to call recession in 1998 but it despite the fact the many prerequisites were in place it happened only in 2001. For those three years "blue chips" stock investment and bonds grow sufficiently to protect against  the forthcoming slump. Most carnage happened to investors who overloaded the portfolio with tech stocks at the last moment then to those who used cost averaging.
     
  • Most bears started to call recession in 2005 and while all signs of the subprime mess were in place their call did not materialize before February 2008.   They were more then two years early. The same thing with early calls happened with dot-com mess.  If a 401K investor heeded those early warnings and moved to the sidelines in 1998 would have lost the chance to make a chunk of money that more or less compensate for 20-30% of losses during 2001-2003 recession (if cost averaging was used all the time). Yes, there were a lot of troubles in the economy, but for two years it did not happen and those who moved their 401K to cash in 2005 were for two years sitting on the sidelines of a pretty significant stock rally. Whether this rally is justified is another question, but there is not much rationality in the stock market anyway.  You can think about merge and acquisition mania, about "Paulson effect" as well as about huge bubble in financial stocks as the reason,  but it does not help if you were on sidelines.
     
  • As Keyes famously noted markets can stay irrational longer then you can stay solvent. This quote probably is mostly about short traders but in some way it is applicable to overly defensive 401K investors too.

According to The New York Times, Baupost Group's Seth Klarman, regarded as one of the world's savviest investment managers, last year allocated a whopping 49.8% of the group's portfolio to cash, up from 45.8% a year earlier.

FPA Capital Fund, run by the legendary Robert Rodriguez, currently has a 40% allocation to cash and cash equivalents, and Fairholme Fund, my personal favorite mutual fund, allocates about 20% to cash. If those heavy-hitters like cash, it might be a good idea to give this patient approach a long, hard look.

At any point of time you can find pretty convincing arguments that crash is just around the corner (next month, next quarter, the next year) but the fact that they are convincing does not mean that this is a right forecast. Seldom such convincing predictions happen in the promised timeframe. In a way it  might be safer to be perma-bull of Siegel variety as you might be more often right then wrong; but if you are wrong 30% of investment can be wiped out in a year of two and it is unclear whether you have enough discipline not to move you holdings into cash in the middle of the turmoil.

At the same time it is not that easy to dismiss this strategy:

• According to the Lehman Aggregate Bond Index, from 1978 until 2005, the long-term average annualized return for bonds was approximately 9%. This rate compares with the approximate 11% average market return for stocks for this same period, according to Ibbotson Analyzer, a modeling tool used for calculating returns. Those retuns probably will never materialize again but even assuming them 30% drop is eqail to at least three years of appreciation. In exchange for their relatively lower returns, fixed-income investments are generally less volatile than stock market returns — which means that the value of stocks tends to rise or fall more sharply than that of bonds. For example, from 1975 to 2005, stocks were generally twice as volatile as fixed-income investments.  TIAA-CREF investing in Bonds- Myths and Realities. Please note that returns are close (9% and 11%) while risk for stocks is twice higher.
   
• While it is denigrated by most fund managers (for obvious reason) 100% in bonds strategy can beat S&P500 during certain 10 year periods (mostly periods ending in recessions). Therefore it can't be denied that this strategy can beat an opposite strategy "100% stock + panic selling" that so many people practiced in 2002 and then in 2008.  And that means that Siegel should eat the corresponding chapter of his book shredded in to borsch :-).  And while in general this strategy has lower returns that 50:50 or  100-your_age stock/bond mixes, it also it might provide better returns then questionable, overly aggressive stock portfolio, or even ad-hoc mixes of many stock funds with periodic "irrational" or blind rebalancing based on the current fashionable trend.

  Also the standard deviation of returns in this strategy is extremely low: assuming inflation will remain in the same zone you can almost plan the future as you are almost guaranteed to get a certain sum at the end of a certain period. If you are earning enough money not to play in stock market, why  should you waist your mental and nerve energy on this  ? Worrying about 401K is the game for poor smacks only ;-).  In other words while this is not an optimal strategy it provides a very simple low end baseline for any 401K investor who can use Excel.  If you cannot beat this strategy during any 3-5 year period you better change the way you are investing. See also a book Stock Cycles: Why Stocks Won't Beat Money Markets over the Next Twenty Years.
   

• If might be a very good starting strategy if stocks are tremendously overvalued at the period when you start or increase 401K investing  (for example this would be an excellent strategy for starters in 1997-1999 and in 2006-2007; they just need to wait several years for a stock drop to start accumulate the stock portion of the portfolio).  If stock prices are driven too high, then getting 5% return on stocks becomes increasingly difficult and many move their investments into too dangerous for 401K territory by increasing their level of risk (typically starting to "diversify" portfolio into international stock funds if they are available.  This is all due to a simple fact that  earnings yields on stocks at 5-6% are very unlikely for stock close to the top like they were in, say 2000, or for a change 2007.

  In a way reasonable success of   "Depression might start tomorrow" strategy proves that Siegelism is wrong and that for certain starting dates and for reasonably long periods (say ten years) that include several  boom-bust cycles stable value funds with average return above 4.5% might even be better then all stock portfolio. Example of such periods are some periods during the last ten years ending in 2003-2006 ( that means that periods started in 1993-1996 and this effect occurs despite two huge bull runs of the stock markets during this decade long periods; this situation actually changed for ten year periods ending in the second half of 2006 till June 2007 when all stock portfolio (Vanguard Total Market Index) now again beats all bonds portfolio (Vanguard bond index) for almost all 10 years periods.
   

• Much depends on the interest rates. Bonds funds with returns below 5% are very dangerous and during those periods a stable value fund (cash) might be a much safer bet.  Such funds can drop significantly in a short period as many investors discover in 2007 with Pimco and other mid-term bond funds.

  The Rule of 72 will tell you how long it takes for an investment to double in value, assuming interest is paid annually and reinvested in the same account. To get your result, simply divide the number 72 by the interest rate you expect to earn on your investment.  For 4% this is almost 20 years.

  Money market funds are not a bad choice if returns on bonds are below 5%. It's really stupid to expose yourself to this risk for let's say 0.3% per year difference in returns. 

  Bonds funds with returns below 5% are very dangerous and during those periods a stable value fund might be a much safer bet.  Never invest in bonds that have returns below 5%. Use cash instead.

  Also with biweekly value averaging  and assuming we started from zero, such a strategy looks competitive to "All S&P500" strategy for older investors in "old bulls" markets in stocks as long as stable value fund interest rate is approximately 4.5% or higher.  During such periods combination of stable value and Vanguard high-yield bond fund bonds (for example 80:20) might improve returns in comparison with "pure" bond funds with the same of less risk (for example Pimco Total return).  My impression is that Vanguard high-yield bond fund generally has higher quality bonds then a typical junk bond fund and thus is less prone to severe declines in bear markets.

There are some tricks that can be played while staying within the limits of this strategy to increase returns. John Waggoner mentioned several of them in his recent column. Most of them are not applicable to 401K accounts but the are worth consideration for other savings, if any:

Yields on money market mutual funds also fall when the Fed cuts rates. The average money fund now yields 4.08%, down from 4.76% in August.

If you count on investment income for part of your living expenses, you'll have to tighten your already-tight belt. A $100,000 CD at 3.54% will give you $295 a month in income, which might be enough if you live in a cave atop Mount Crumpit. If you don't, you'll want to look for investments that generate more income.

Normally, you can receive higher rates by investing in a longer-term CD. But these aren't normal times. The average five-year CD yields 3.76%. On a $100,000 investment, a 3.76% yield would earn you an additional $18 a month, or about enough for a can of Who-hash.

Also, you don't want to lock in a lousy 3.76% for the next five years. Rates are more likely to rise than fall in the coming years, because of the very real threat of inflation. Inflation, at 4.3% in November, will gobble up all your interest if prices continue to rise at their current clip.

Look for banks that really want to borrow your money. Countrywide Bank, for example, will pay you 5.5% on a six-month CD.

The trade-off: Many banks that offer high deposit yields have been in the news lately, and the news hasn't been good. Countrywide, once a leading subprime lender, has been plagued by lower lending volume and rising defaults.

These banks' troubles shouldn't haunt you if you stay within the federal deposit insurance limits. (You're insured for up to $100,000 of your deposits.) The insurance is quite generous: You also enjoy separate $250,000 insurance for your individual retirement accounts, for example. For a complete rundown, go to www.fdic.gov.

If you want higher yields, though, you'll have to take more risk — including that your principal might fall. One suggestion: closed-end bond funds. Unlike most mutual funds, closed-end funds issue a set number of shares that trade on the stock exchanges, just like stocks. The twist: Many times, the market price of closed-end funds falls below the value of the fund's holdings.

Thanks to the meltdown in the credit markets, many closed-end bond funds have been clobbered. That's bad news for people who had bought the funds. But it's good news if you're now looking for high yields at bargain prices. Thomas Herzfeld, a closed-end specialist, says closed-end bond funds now offer some of the best buys he's seen in nearly 40 years.

Consider, for example, Putnam Premier Income Trust (PPT). Wednesday, the fund's shares sold for $6.14. But the fund held securities worth $7.11 a share. In other words, you'd be buying the fund's shares for a 13.6% discount to their real value.

More important, the fund's yield is a generous 5.8%, according to the Closed-End Fund Association (www.closed-endfunds.com). Other closed-end bond funds that Herzfeld likes are in the chart.

All-in-all simple binary allocations like static 50-50 (or close to it in a range approximately 60:40 to  40:60 )  split between "safe" and "risky" bonds as well as recursive application of of lifecycle strategy (100 - your age and similar), but now to a bond portfolio. 

Based on just simulations that I performed it looks like static 50:50 split between TIPS and corporate junk bonds provides not bad returns and a reasonable level of risk in comparison with the 100% in stable value portfolio. But again I a computer expert, not financial expert.

But there are really bad periods for this combination and junk funds in October 2008 look really bad (or suicidal, if you wish) with drops approaching declines of S&P500. At the same time 50/50 portfolio is extremely easy to rebalance.  See  also Life cycle fund investors Doing it wrong - Personal Finance - MSNBC.com.

All-in-all keeping all your money in money market fund or mixture of bond funds without any stock component might be an overly defensive strategy. I suspect that there is a minimum amount of stocks in portfolio below which the risk increases. Such a minimum might be in the range 10-30% depending on your personality (abrupt moves due to discomfort usually damage return greatly in a long run) and  stocks can utility stocks that carry some dividend.

And with good selection of bond fund and stock index the risk probably stays within bounds similar to all bond portfolio till probably 30-40%. Then it rises but until probably 60% this rise is rather slow. That means that defensive lifecycle strategies (and lifecycle funds, see below) might be able to provide better returns then "cash only/bonds only" 401K portfolios with only minimally higher risk.

Bond funds are radically different from holding actual bonds

Here is an apt quote that describes the main problem with bond funds in 401K portfolio, the fact that your principal is at risk:

MANY INVESTORS, wary about buying bonds directly, often opt instead for bond funds, thinking, perhaps, that there is safety in numbers. Big mistake. Bond funds can be even trickier than bonds themselves because -- unlike the implication in their name -- they are not really fixed-income investments. Even when a mutual fund's portfolio is composed entirely of bonds, the fund itself has neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date -- the two key fixed characteristics of individual bonds. [Bond vs. Bond Funds (One Bond Strategy) SmartMoney.com]

Bond funds are not panacea in comparison with stock funds, even taking into account all machination with stock prices.  As we discussed TIPs are less volatile then most is should be a art of bond portfolio. You might benefit from replacing some part of stock holding with junk bond fund as they behave similarly (they are highly correlated) but have lesser volatility (interest also helps to diminish volatility during severe downturns; for example 30% drop of junk bond price with 10% interest means approximately 20% drop in your investment value). 

But with junk funds like with stocks timing is everything: they are not suitable target for cost averaging. As PIMCO Gross notes by simply researching historical annual high yield default rates (5%), multiplying that by loss of principal in bankruptcy (60%), and coming up with an expected loss of 3% over the life of future loans. So fair return for junk bonds is LIBOR + 300 or more. In other words as Gross stresses "for LIBOR+250 high yield lenders are giving away money!"

It is important to understand that in current circumstances stable value funds can be a blessing as they are the only reliable hedge available to 401K investors.  And if somebody is concerned about returns it's relevant to remind that average returns for 401K investors are negative after inflation. So you have nothing to lose and get peace of mind which is also very important.   Money market accounts (stable value funds in 401K terminology) are the most liquid and less dangerous of bond funds and they should probably be integral part of any 401K portfolio, especially in cases where you  cannot buy a bond fund that has return above 5%.

Bond funds are much complex financial instrument than bonds themselves because -- unlike the implication in their name -- they are not really fixed-income investments.   Bond funds do not guarantee the return on your principal after certain number of years and for intermediate term and long term bond funds in fact can endanger your principal even if you hold them for a number of years less then maturity.  Also returns can fluctuate year to year.

One of the reason is that bonds in bond fund portfolio constantly rotate.  If you try to withdraw money from the bond fund during the period of Fed tightening you can lose part of your principal. That's why intermediate with return below 3.5% and long term bond funds with returns below 5% (including inflation-protected securities funds -- TIPS) are very risky to hold and are not safe financial instruments at all. 

Inflation rate plus 2% rule for 10 year bonds

If we assume that stable value fund has zero effective return and compensates just for inflation, to sacrifices stability of the principal for just 1% of extra return for 10 year bonds is risky. You need at least 2% premium.  

For the same reason buying bond indexes with low interest rate are much more questionable idea then buying stock indexes. Long term high quality bond funds seldom worth either the added risk or the added cost. Treasury Direct might be a simpler and better way to manage your high quality bond port of the portfolio during the retirement as government bonds are tax free. 

Investment fees associated with managing bond funds investments (mutual funds fees) are assessed as a percentage of assets invested, but for bond funds this is a completely inaccurate method.  Bond fund can be considered partnership between you and bond fund advisors were you provide all the capital and they provide management. That means that results should be calculated as a percentage of return after inflation. For example Pimco with its eloquent manager Bill Gross are taking approximately 0.5% in fees and has after fees return of approximately 4.5%. That means that they are taking 11% of net returns for the management of funds without even considering inflation. If we are taking about returns after inflation and assuming inflation to be around 3% a year, they are taking 0.5/1.5=33% of return on your capital and at the same time spending a lot of your money trying to persuade you that this an extremely good deal.

That's why long term bonds funds that has returns below 5% (or Libor rate if you need to be more exact) are generally a bad deal and you should consider using shorter duration funds instead. I think it is prudent to avoid buying long term bonds funds with below 5% returns in 401K portfolio. Please note that bonds funds fees are not specifically identified on statements, but can be found in fund prospects and on Yahoo finance.  See A Look At 401(k) Plan Fees for Employees for details.

Bonds are especially vulnerable during "credit crunch" when even A and AA bonds can be affected (even AAA were affected during Great Depression). Cutting interest rates during such a crisis (a typical government reaction) increases inflation that has the effect of transferring wealth from creditors to debtors. That means transferring wealth away from bond investors.

From other point of view interest rates are just to consider them to be the price of money. And low interest rates suggest devalued money and high monetary supply growth. That is yet another way to explain why bond funds with returns below 5% are risky to hold. In such cases stable value funds are blessing.  Gold might be blessing too.

And the last but not least: while bond funds fees usually are stated as the percentage of assets they in reality should be stated as the percentage of interest earned. That helps to see more realistic picture about who is the prime beneficiary of the money you put in the fund and how big the second largest beneficiary share is.  See above calculation for PIMCO Total Return fund.

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