Bond Mistake?

In June 2003, at the age of 60, Gabe decided to retire.

He and his wife Della, also 60, decided that she would continue to work until she could qualify for Social Security benefits. Gabe took the money from his 401(k)

retirement plan ($600,000) and bought shares in a longterm, AAA-rated, corporate bond fund, thinking he wanted to be conservative with their nest egg. Recent stock market declines had reinforced his belief that stocks were too risky. In June 2003, 20-year AAA corporate bonds yielded about 5.0 percent. Gabe and Della figured that the income from their bond fund, combined with Della’s income, would be plenty to live on. The first year, Gabe’s mutual funds generated

$30,000 in income before taxes. Although this was about half what he had earned while working, he was pleased to find that they didn’t have to dip into the principal to support their lifestyle. But as rates on AAA corporate bonds rose to about 6 percent by June 2004, Gabe was alarmed to see that the value of his bond mutual fund shares declined to $533,000. He and Della were confused; they had thought that bonds were safe investments. They wonder if they should switch to a different type of investment.

1. Is the asset allocation chosen by this couple appropriate for their life situation and risk tolerance?

Explain.

2. Explain why the value of Gabe and Della’s bond mutual fund has declined. (Hint: consider what happens to the prices of bonds when interest rates rise.)