According to the Investment Company Institute, 2010 was the second consecutive year of record investment in fixed income mutual funds. Net inflows finally started to slow down toward the end of the year, but as of November there was a staggering $2.65 trillion invested in fixed income mutual funds (taxable & municipal combined), or roughly  22% of the total of all invested mutual fund assets ($11.5 trillion).

Most investors assume that bond funds are safer than stock funds, which is why they were so popular following the Great Crash of 2008. And it’s true: they are typically less volatile than stock funds. But they certainly aren’t risk-free, so it’s essential that advisors understand the risks inherent in these funds so they can explain them to clients and, more importantly, think about ways to mitigate them.

One of the primary risks facing bond fund investors is interest rate risk. Simply put, if interest rates increase fund values will decrease (and vice versa). Depending on the type of fund, the loss could be quite substantial. For example, a long term bond fund with a duration of 10 years would lose 10% if long term rates increase a single point.

Individual bonds, on the other hand, can experience an unrealized loss during a rising rate environment, but as long as they’re held to maturity (and no defaults occur) the payoff is certain. That’s why bonds are known as “fixed income”: they pay a fixed coupon during the holding period and a predetermined, contractually obligated amount at maturity.

Of course, nobody knows precisely where rates will go in 2011, but given how low current rates are relative to historical levels there is clearly more downside risk than upside potential. Ben Bernanke and the Federal Reserve are doing their best to keep interest rates low with QE2, a $600 billion long term Treasury-buying program. But in spite of their efforts, the 10-year Treasury has already increased roughly 1% since early October.

And not surprisingly, bond fund values have suffered. Perhaps the most striking example is TLT, an iShares ETF


that invests exclusively in long term Treasuries. In just three months the fund has fallen from its October 6 peak of 104.5 to a January 18 close of 91.41, a loss of 12.5% (note that this includes dividend payments).

TLT returns vs. 10-year US Treasury prices

Understanding Volatility, Limiting Losses

As a financial advisor, you need to be prepared not only to discuss this type of volatility with your clients during 2011, but to think about ways to limit the losses they might face. One obvious solution is to liquidate all of your bond fund positions and replace them with individual bonds, but that is likely too extreme for most advisors.

A more modest and realistic approach is to create a blended portfolio that utilizes a mixture of funds and individual bonds to limit your clients’ downside. The individual bonds effectively act as a floor in their portfolio, ensuring that at least a portion of their assets will deliver predictable income and dampen the overall volatility.

Another benefit of a blended approach is that it allows advisors to utilize funds when they are the most efficient way to access certain markets. For example, buying foreign or emerging market debt directly is not easy, so mutual funds are a great solution. Likewise, mutual funds provide instant diversification in the high yield market, which helps reduce default risk.

But there are plenty of other fixed income markets, including U.S. Treasuries, agencies, municipals, and investment grade corporates, where individual bonds can be easily traded. Advisors should strongly consider incorporating these types of bonds into their clients’ portfolios as a practical, cost-effective way to manage the downside risks inherent in funds.

In Part II of this series we’ll discuss some specifics about how advisors can access the credit markets for their clients and buy individual bonds.