In case the bond bubble bursts

Plan advisors are likely to have their hands full very soon. 

Either they’ll find themselves spending a lot of time educating plan participants on the dangers — yes, that’s right, dangers — bond funds can introduce into their retirement plans, or they’re liable to find themselves facing some very disgruntled employees, and even retirees, who loaded up on the funds to minimize risk as they got closer to retirement or relied on them to provide income during retirement.

Why? Two main reasons: First, a rise in interest rates in a recovering economy, which, when it occurs, will drive down the prices of existing bonds as newer-issue bonds offer coupons with greater rates of return. The longer the term of the existing bond, the more magnified that part of the problem becomes.

Second, the risk inherent in bond funds — a factor that injects additional risk into plans that, as participants approach retirement, urge them to focus on safety.

We’ll look at the second factor first, since that’s a problem that exists whether interest rates rise, fall or stay the same.

For years, the mantra of bonds has been safety. Bonds have been a buy-and-hold staple — they provide fixed income while held and, if held to maturity, return principal to the bondholder. While that’s still true, very few retirement plan participants have access to actual bonds in their retirement plans. Instead, they’re offered bond funds, which, in their naïveté, most believe to be the same thing, offering the same safety and the same reliable return.

But they’re wrong. Plan participants can be amazingly uninformed about the options in their plans, and most fail to realize that not only are bond funds not bonds, but that they carry the same risks as everyday equities.

Stan Richelson of Scarsdale Investment Group, which builds portfolios from bonds and only bonds, ticks off the reasons to be on guard.

First of all, it’s “not possible” to know exactly how much return a bond fund will deliver, because there are too many variables: future interest rates, the diversification of the fund that holds the bonds, the maturity of the bonds the fund holds, the credit positioning of the fund.

Then there are the expenses of the fund itself: trading costs; purchase or exit fees; management, maintenance and administrative fees; 12b-1 fees; low balance fee; other costs.

All these things affect the return, but an actual bond would not experience any of them except the level of future interest rates — and that would only affect how much the bond could be sold for, should the bondholder decide not to hold it to maturity — and possibly a broker’s commission, if the bond were not purchased directly.

Second, the need to cover all those costs means that a bond fund may choose to buy lower-grade (or riskier) bonds — not something you want to do if you’re thinking of safety and capital preservation. While riskier bonds may provide a higher return, they also offer a higher risk of default.

Third, some bond funds hold derivatives and other instruments that, again, are not bonds. The funds may also use leverage, thus upping the volatility factor.

And fourth, even if participants opt for a passively managed fund or ETF, the lack of availability of some of the bonds in an index may preclude the fund from owning them.

Richelson noted that because the bond market is “incredibly illiquid” compared with the stock market, with most bonds not trading on a given day, an ETF will be priced via the use of mathematical algorithms, which can lead to tracking errors. This, said Richelson, could mean that the price will end up substantially different from market conditions so that a bond ETF could cost an investor “a lot more or less than the ETF is actually worth.”

Now, back to the first problem.

“We’ve already seen a little bit of experience with (what can happen if interest rates rise),” said Marcy Supovitz, president of the National Association of Plan Advisors. “Just based on (Fed Chairman Ben) Bernanke’s hints back in early May (that quantitative easing would slow), the yield on 10-year Treasuries jumped to 2.6 percent from 1.6 percent … and that caused investors to pull $60 billion out of bond mutual funds — but they were doing that after already taking a loss.”

According to John Geissinger, partner at Hewitt EnnisKnupp, an Aon company, “The challenge going forward is, quite frankly, how do you minimize potential losses in the face of rising rates?