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?

“For a core bond fund that pretty much has the same interest-rate risk as the overall bond market, if overall interest rates were to rise 1, 2 or 3 percent, the value of that portfolio in terms of pricing would be expected to go down 5, 10, and 15 percent, respectively. We see what the yields are.”

The real challenge with bond funds or fixed-income funds, he said, is how to invest in a fixed-income class when there’s not really any income being generated by it.

“Part of what helped insulate and reduce volatility in bond funds in the past was a decent level of income,” he said. “Now that buffer has been compressed. And if you have a longer-term fund, for example, a 10-year Treasury that yields 2.6 percent today, and if rates went up 3 percent, the anticipated price decline would be approximately 27 percent; 2.6 percent of income does not buffer that loss.”

So what does that mean for plan participants?

According to Geissinger, “The age groups in the ‘sweet spot’ of pain are those approaching retirement. Also, the ones really challenged at this point in time are those who have recently retired and are trying to have portfolios that have reduced volatility but are also dependent on income to support retirement.

“They’re faced with a very double-edged sword, because income just isn’t available in a lot of sectors of the marketplace — and if you were tempted to extend maturity, that would highlight potential losses if rates rise. Those are the ones who need to be more creative in designing portfolios protected from an overall rise in rates.”

Indeed, participants who have followed past common practice and transferred money in their plan from equities into bond funds as they approach retirement have already seen losses, and could see considerably larger ones should rates continue to rise and the value of bond funds continue to fall.

Said Supovitz: “Some of the biggest bond funds in the 401(k) universe took major hits just from May 1 to July 1. … Participants who watch these things closely would have been very surprised by that.”

So what’s to be done?

More education of plan participants, for one, and advisors are already working on that, in addition to other strategies.

Supovitz said that even back in March, plan advisors were already saying that “they were preparing participants for a very different bond market than it has been in the past, because we know the average 401(k) participant does not understand what’s going on in the big picture, and many of them will be in for a shock.”

“There are various things we’re all doing to prepare, not the least of which is more participant education on the various risks of investments, because we’re coming out of pretty much a decade-long bull market for bonds, and many 401(k) participants choose their investments based on performance in the past,” she said.

Smart plan advisors are looking at adding stable value funds, if available, to plans, said Supovitz, or replacing the bond portion of model portfolios with stable value funds, as well as adding all-in-one bond funds and shorter-duration bond funds.

Geissinger pointed out that fund managers “have been very proactive” in working on solutions.

One option is the unconstrained bond fund, which he says is “designed not to look like the overall bond market; they’re the antithesis of bond funds (because they) can shorten the volatility of the average portfolio, and look both globally and up and down the credit spectrum for more income” even as rates are rising.

“A lot of times when we look at plans,” said Geissinger, “there’s a host of options available on the equity side, with fewer options on the fixed-income side. We used to think bonds were boring,” he said, “but now we recommend plan sponsors think about having options available with different interest-rate sensitivity, so participants can manage. Stable value plus core bond funds do not provide enough tools to manage a portfolio.”

If there’s a silver lining in the situation, said Geissinger, it’s that “the savers and retirees actually want and need higher rates,” so that there’s a positive rate of return on investments.

“So the issue is, how do you protect yourself during that transition? … (It) can be painful if you’re not prepared for it. Protect yourself, so you can live another day.”