As a 401(k) plan sponsor, you try your hardest to do your best for your employees. You’re responsible for studying complex issues like investment theory and risk your own personal liability to make decisions in areas like this, that, quite frankly, you have not had formal training in. Yet you do. For the good of your employees.
And when decades of accumulated investment wisdom demands you accept the platitude that a good portfolio contains some balance of stocks and bonds, you accept it. Alas, unbeknownst to you, sometimes a bond is not a bond. Because of that, you risk being caught unawares – and you’re employees risk losing a sizable chunk of their hard-earned retirement savings.
What’s a plan sponsor to do? I leave answering this question to others (and they do it here: “Anticipating the Bond Bubble Burst: Protecting Your 401(k),” FiduciaryNews.com, March 19, 2013). I want to focus on the root cause of the problem.
Too many investors – including professionals who ought to know better – mistakenly believe bond funds are the same animal as bonds. Let’s cut to the quick: They aren’t. Bond funds are technically derivatively equity instruments composed of bonds. Don’t be confused by their underlying components. Bond funds are equities just like bank stocks, utility companies and real estate investment trusts are equities. (OK, OK, technically the latter is a trust, so let’s just say real estate sector funds.)
I choose those three readily accepted equity industry sectors with purpose. Most advisers rightfully classify them in the equity class. Like bonds, the movement of their price can be tied to the rise and fall of interest rates. Unlike bonds, they neither promise to pay a fixed income nor do they promise to return your original investment back to you in full upon a pre-determined maturity date.
That’s what bonds do. They pay a fixed income and they promise to return your original investment back to you on the pre-determined maturity date.
Bond funds, on the other hand, do the opposite of bonds. Like the aforementioned equity sectors, bond funds do not pay a fixed income, they pay a variable income. Like those similar dividend-oriented stocks we brought up, bond funds do not promise to pay you back your original investment in full, but subject you to the variegates of daily pricing changes. To whit, you can only sell your bond fund for what the market will bear. Unlike a bond, you cannot hold it through to maturity and recover your full initial investment.
In a nutshell: Bond funds are not bonds, they are stocks. They have risk/return characteristics similar to the traditional dividend paying stock class.
The confusion stems from the fact bond funds often offer return ranges similar to bonds (i.e., a more conservative, low-risk, low-return profile). But that doesn’t make them a bond any more than we can make a utility company with a similar risk/return profile a bond. As they say, some things are simply not biologically possible.
In the end, we are confronted with these undeniable facts: if it looks like a stock, walks like a stock and talks like a stock, then it’s a stock, even if the stock is made up only of bonds. Think was a bank stock. A bank stock is a stock of a company that owns (but on the long end and on the short end) bonds. Just like a bond fund.
Bond funds do not offer the reliable flow of income like an individual bond does. Bond funds do not offer the safety of principal like an individual bond does. In short, bond funds are not bonds.
And it’s this lack of safety of principal where 401(k) plan sponsors will find their greatest liability. There’s a good chance employees think bond funds are bonds. When interest rates go up (as they will inevitably do), many otherwise calm employees will discover the harsh reality that bond funds are not bonds. If the 401(k) plan sponsor has a fiduciary adviser, then the 401(k) plan sponsor can rightly shift this fiduciary liability to the adviser. If the 401(k) plan sponsor doesn’t have a fiduciary adviser, then guess where that fiduciary liability lies.
Are you prepared to survive the coming Bondocalypse?