What the safe part of your 401(k) still can, and can't, do

The safest part of your 401(k) isn't as safe as it used to be. But there's still nothing safer, fund managers say.

Investors have long taken comfort in the steady returns their bond funds have provided, particularly when stocks go on another of their gut-wrenching drops. But the safety blanket is getting more threadbare, a result of simple math. Bonds don't pay as much interest as they used to, following a decades-long drop in interest rates. That means bonds pay less in income and also raises the threat of a rise in interest rates. Higher rates mean prices for bonds, whether individual ones in your brokerage account or the ones in a bond fund you own, will fall because their payouts look less attractive than those of newly issued bonds.

Even though bond funds provide less cushion than before, they still are the best defense for a 401(k) account, fund managers say. Bond funds will still hold up better than stocks during downturns. And investors may be in need of some safety soon. U.S. stocks are more expensive relative to their earnings after more than tripling since early 2009, and Wall Street questions how much more they can rise without strong growth in profits. President Trump's promise to shake up the status quo could also mean big swings for stocks.

Bonds will likely have positive returns in 2017, though smaller than in prior years, making for a boring year, says Colin Lundgren, head of U.S. fixed income at Columbia Threadneedle. But that's not a bad thing.

"I think boring is OK in this environment because other parts of your portfolio could be far more volatile," he says. "In a world in which the equity market can go up or down dramatically based on the latest tweet or global event, this provides a stabilizing force."

Here's a look at what fund managers say investors can, and can't, expect their bond funds to do for their savings:

— WHAT WOULD A TERRIBLE YEAR FOR BOND FUNDS LOOK LIKE?

Critics have been warning of a bubble in the bond market for years, so it's natural to ask how bad a bond-fund investment could go. The worst year for high-quality U.S. bonds in the last four decades was 1994, when the Federal Reserve raised interest rates six times. Bonds lost a shade less than 3 percent that year.

"And we think of that as a disaster," says Lundgren.

Compare that with the 37 percent loss that the largest stock mutual fund by assets suffered in 2008, when the financial crisis was at full flame. And that's just one of four times that stocks have lost more than 10 percent in a year since 2000.

Of course, rates are lower today than in 1994. So losses could potentially be bigger if the Fed begins raising rates sharply and at an aggressive pace. But fund managers say a worst-case scenario would still have annual losses of below 10 percent for a high-quality bond fund.

"The math of bonds means that it's difficult for bonds to go down more than 3 or 4 percent in a year," says John Smet, fixed-income portfolio manager at Capital Group, parent of American Funds.

— WHAT KIND OF RETURNS SHOULD I BE LOOKING FOR IN 2017?

Start with how much interest bonds are paying out. For high-quality U.S. bonds, it's close to 3 percent. Returns could be roughly there, or even better if interest rates fall, which would push up prices.

Most economists expect the opposite to happen, though, and a rise in rates would mean high-quality U.S. bonds would return less than 3 percent in 2017. If rates rise enough, it could push bond funds to losses for the year. Last year, the average intermediate-term bond fund returned 3.2 percent, but only after a 2.5 percent loss in the fourth quarter trimmed returns.

Bonds issued by companies with weak credit ratings, also known as junk or high-yield bonds, offer higher interest rates, which means a higher starting point for returns. But those 6 percent yields come with more risk: Junk-rated issuers are more likely to fail to make good on their interest payments.

That's why many bond fund managers say to expect returns in the low single digits, possibly in the mid-single digits, for 2017.

— WHAT ABOUT INFLATION AND THE FED?

This is the big threat. If inflation spikes and forces the Fed to catch up by aggressively raising rates, it would move the bond market toward its worst-case scenario.

Inflation is indeed on the rise, but fund managers say it still appears manageable. And the U.S. economy doesn't look likely to accelerate much in 2017, Smet says. That could mean the Fed raises rates fewer times than investors are expecting.

"If you think back to last year at this time, everyone was saying the Fed would raises rates two times, maybe three times, in 2016," Smet says. The Fed ended up raising rates just once. "The surprise to the market this year may be that the Fed is not able to raise rates two times."

— CAN BONDS STILL BE A STABILIZER GIVEN THE LOW YIELDS?

They have been recently. A year ago, stocks tumbled on worries that a recession may be lurking, and the Standard & Poor's 500 index lost 5 percent that January. The average intermediate-term bond fund returned 0.8 percent during the same month, according to Morningstar. That's not much, and it's less than bond funds returned in similar down months for stocks in prior decades, but it still provided comfort to investors who held a mix of stocks and bonds in their retirement accounts.

"Even in a terrible market for bonds, you still get much better protection than you would get in equity markets," says Kate Nixon, chief investment officer at Northern Trust Wealth Management. "It's tempting to say, 'Ditch your bonds' because of interest rates, but we don't abide by that. You need to have that diversification, to allow you to live to fight another day in the equity market."