As investors have recently rediscovered, stocks have risks. So do bonds.

When Fed Chairman Jerome Powell recently hinted his agency could boost rates as many as four times this year, volatility ensued. The stock turbulence demonstrated that weakness may be looming for bonds, as well.

“One of the biggest misconceptions investors have is thinking that their portfolios are safe because they are mostly invested in bond funds,” says Ron Weiner, managing director of RDM Financial Group at HighTower in Westport, Connecticut.

Clients may soon be in for a “rude awakening” he warns. Rising bond yields coupled with relatively high fees hidden inside a number of fixed-income investment vehicles, could lead to some underwhelming returns for bond funds this year, Weiner says.

Image: Bloomberg
Image: Bloomberg

As of mid-March, the benchmark Bloomberg Barclays Aggregate bond market index was down almost 2% year-to-date. Twice in the past two decades (in 1999 and again in 2013), bond funds have suffered down years on fears of inflation and rising interest rates, in addition to some losses in 2008 during the financial crisis.

Weiner believes that a “nightmare of negative investor returns” could take place, with bond fund investors possibly experiencing multiple monthly or yearly losses. How can financial planners explain the risks to clients and select bond funds that line up with their risk tolerance?

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How can financial planners explain the risks to clients and select bond funds that line up with their risk tolerance?

One approach is to focus on credit risk, the chance that issuers will not meet their interest payout and bond redemption promises.

“When we explain bonds and bond funds to clients, we use a car analogy, where stocks serve as the engine and the bonds serve as the airbag,” says Natalie Colley, an analyst with Francis Financial, a wealth management firm in New York. “Investing in low-quality bonds is the equivalent of filling your car air bag with shrapnel.”

This approach is “pretty intuitive,” Colley says. “Any event that causes stock prices to fall — interest rate hikes, geo-political issues, weak economy, etc. — can cause the airbag to deploy,” she says, spreading shrapnel that can damage the investment plan.

“Bonds are there to cushion your portfolio in a market downturn, so it's incredibly important that they be of high quality,” she adds. “Bonds are intended to be the unsexy, vanilla piece of the portfolio. Maintaining a high-quality bond cushion allows you to take on increased risk in other parts of your portfolio. That's where stocks come into play.”

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Clients frequently expect unrealistically high returns from bonds.

Clients frequently expect unrealistically high returns from bonds, Colley says. “Yes, it’s possible to receive higher returns from low-quality, risky bonds,” she says. “We often see them in the portfolios of clients who come to us for a second opinion. We frequently liquidate the junk bonds when clients come on board.”

Funds holding low-quality bonds may have credit risk but funds with higher quality bonds are by no means risk free. “Rising bond yields would likely have an impact on several different types of bond funds,” Weiner says. “Bond funds that mainly invest in high-quality securities would be more affected because they have lower coupons and thus less support to protect them during periods of rising rates.” (See the accompanying table, "If interest rates increase by one percentage point" for the federal government’s illustration of how rising rates can devalue bonds.)

Weiner adds that a rise in yields may cause a number of investors to pull money from bonds funds, especially core funds.

“This could force portfolio managers of core bond funds to sell securities in order to meet redemptions,” he says. “If bond fund managers are forced to sell various investments to meet growing redemptions, regardless of how strategic they are to the investment portfolio, this could be to the detriment of all shareholders.”

Lack of maturity: Credit risk and interest rate risk can impact individual debt issues, yet bond funds have another possible trap. Typically, there is no scheduled return of investment.

“Individual bonds are different than bond funds because they have stated maturity dates,” says Weiner. “Investors know what the yield to maturity — or ‘yield to worst’ if a bond is callable — will be at the time of original purchase.” With bond funds, investors might see share value drop and never rebound.

Timothy Hayes, founder and president of Landmark Financial Advisory Services in Pittsford, New York, acknowledges this possibility. “The lack of a certain maturation or return of principal is not the least risk of holding bond funds,” he says.

Nevertheless, Hayes assures clients that price declines due to interest rate rises aren’t necessarily the end of the story. “I generally suggest to clients that if we've determined bond funds make sense for them, we have to accept the fact that the funds' share prices are going to fluctuate,” he says. “There always will be some risk of their principal value falling below the purchase price, if only temporarily.”

On the other hand, Hayes points out that such price declines can be offset by ongoing reinvestment of the income distributions, at higher rates. “I stress to clients that, over time, even in a rising interest rate environment, where we would expect the funds’ net asset value to decline, the manager can reinvest the proceeds in higher yielding new bonds as the individual securities within the fund’s portfolio mature,” he says. “That should eventually result in the fund's income yield ‘equilibrating’ to the higher interest rate environment.”

In essence, Hayes explains that a rate-caused decline in share price can be only temporary, if a client’s holding period approximates the fund's duration. “They should be better off after a rate rise, not worse off, as long as they can stay the course," he says. “I know from personal experience that this is logical: as rates rise, a bond fund manager ought to be able to re-position the portfolio in now higher yielding bonds as older bonds mature.”

Restful nights: Explaining the various risks of bond funds can help advisors develop clients’ fixed-income allocations.

“Most clients have a sense of how they feel about risk,” Colley says. Her firm shows clients an illustration of the worst yearly returns for various stock and bond blends over the past 100 years. The examples include portfolios with 80% stocks and 20% bonds, or a 60-40 mix, for example.

“We ask them, ‘which of these negative returns, if you were to see this in your portfolio in any year, would cause you to lose sleep at night?’” Colley says. “We need to be more conservative than that.”

Therefore, the vast majority of bonds used by Colley’s firm are very high quality. “We have a mix of bond funds that we like to use, which vary by bond maturity,” she says. “The funds that we use now are either short-term or intermediate-term,” reducing interest-rate risk as well as credit risk.

“Risk tolerance does not dictate the percentage allocation among bond funds,” Colley says, so the fund mix remains constant while the allocation to fixed income can vary. “If we have a client who has a higher risk tolerance, we take more risk in stocks.”

Donald Jay Korn

Donald Jay Korn

Donald Jay Korn is a contributing writer for Financial Planning in New York. He also writes regularly for On Wall Street.