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How the ERISA Fiduciary Can Avoid the 3rd Deadly Sin – Bond Insecurity

October 13
22:34 2010

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

Evidence suggests the bonds of today are not the same bonds of Ben Graham’s time. Until very recently, today’s bonds have paid higher interest rates (both nominal and inflation adjusted). Extreme prices have made bonds more sensitive to 1146258_64781197_shield_stock_xchng_royalty_free_300changes in interest rates compared to the bonds of the previous generation. As a result of this and other factors, today’s bonds have a price volatility nearly equal to that of stocks. We therefore must conclude today’s bonds no longer represent the safe holding pen (i.e., “risk-free” investment) of Ben Graham’s time.

So what should represent the “risk-free” investment in today’s environment? Whereas more than a half century ago Ben Graham advocated the use of bonds as a safe harbor in his portfolios, today’s investors should use “cash” – money-market funds, Treasury Bills or even short-term Treasury Notes (i.e., those maturing within five years). This, of course, assumes the investor agrees with Ben Graham in the first place and does not wish to own a portfolio always fully invested in stocks.

For a traditional conservative (as opposed to speculative) long-term investor seeking higher returns using traditional investments, stocks and cash remain the only viable investment vehicles. The classic benefits of bonds no longer exist. We’ve learned from institutional investors the dangers of emphasizing portfolio income (i.e., the 1st Deadly Sin). Instead, most professionals emphasize total return – something stocks do much better than bonds. Bond prices no longer display the reduced volatility they have shown in the past. Long-term investors need to remember that today’s bonds cannot reduce portfolio volatility in the same way bonds could at the advent of the Modern Portfolio Theory era.

Many investors, especially those who invest their 401k plans, continue make this very sneaky mistake. How? They buy a bond mutual fund thinking it’s a bond. I call it sneaky because financial professionals and the industry as a whole places bond funds in the same asset category as other fixed-income instruments. The prices of mutual funds, by definition, fluctuate on a daily basis. Therefore, unlike a true bond, a bond fund cannot guarantee you will receive your principal back in whole. Hmmm, a risk to one’s principal, isn’t that the definition of a stock?

It gets worse. Because a mutual fund’s price changes daily, its yield also changes on a daily basis. Portfolio turnover, either through maturing securities, forced sales due to redemptions or forced purchases due to cash inflows, may also result in a change in yield. Therefore, unlike a bond, a bond fund cannot guarantee a fixed income. Wait, isn’t “fixed” income part of the definition of a bond? Uh, oh!

Unlike a bond, bond funds do not mature at a certain date. If you need to invest in a fixed-income instrument, buy a bond. Don’t ever buy a bond fund thinking you are diversifying into fixed-income assets. A bond fund more closely approximates an income-oriented equity fund than it does a fixed-income asset.

Here’s an aside, (which I know I shouldn’t get into because some fools will use this as an excuse to buy a bond fund when they shouldn’t): The foregoing is not to say one can’t achieve higher rates of return using bonds. Specialized portfolios of non-risk-free bonds should, theoretically, achieve higher returns commensurate with the higher risk involved in those bonds. These types of investments may be appropriate for speculative investors, but conservative investors need to be fully aware of the downside. Remember, treat these bond funds as though they are part of the risky (a.k.a. “equity”) portion of your investments, not your risk-free (a.k.a. “fixed-income”) portion.

Where does leave the 401k fiduciary? Clearly, including a “bond” asset class in the menu of investment options seems the correct thing to do. However, it’s very difficult to offer a true fixed income asset. As we’ve stated, bond mutual funds – even ones that invest in bonds with short-term maturities – really act like equities, not bonds. Two alternatives do approach the intended objectives of the bond class.

Money market funds stand out as the safest alternative. The problems with these investments are two-fold: the income is not fixed and the yield is typically much smaller than that of true bonds. On the other hand, money markets have (knock on wood) successfully achieved their promise of maintaining the dollar; thus, they’ve preserved the initial investment, one of the primary considerations of Graham’s “risk-free” portion of the portfolio.

Stable value funds like GICs offer another safer alternative to bond funds. Not only do they protect the initial investment, but they usually feature higher yields compared to money market funds. These instruments, unfortunately, aren’t entirely risk free – and we’re not just talking about the reinvestment risk of maintaining higher yields when the underlying contracts expire. As anyone who lived through the credit crisis of 2008, these products are vulnerable to broad as well as company specific financial crises. For example, the collapse of an insurer of an underlying contract can eradicate the value of that contract; thus, eat into principal. In addition, and this is particularly important for compliance officers, these offerings generally are not regulated like mutual funds, so obtaining relevant information – including fees – may be difficult.

The ERISA fiduciary faces many challenges when attempting to avoid the 3rd Deadly Sin – Bond Insecurity. The greatest potential for liability exists in 401k plans, where investors can rarely, if ever, invest directly in bonds. Without education, both plan sponsors and their employees can mistakenly invest in options thinking they offer the traditional protections of bonds when they really behave like stocks. The risk intensifies during periods of low interest rates as investors who chase “safe” investments for higher yields might be surprised when the value of the investments come crashing down as interest rates rise.

Bond investing is not for the faint-hearted. Because of the myriad ways one can use – and misuse – bonds, buying them represents one of the most important caveat emptor scenarios in the world of investing.

Part I: How the Fiduciary can Explain the Practical Differences Between Stocks and Bonds
Part II: Defining the Perfect Bond: What Every Plan Sponsor Must Know About Bonds – Before They Crash!
Part III: 401k Plan Sponsors Beware: Are You Lighting a Match in the Powder Room Despite 1995 Study?
Part IV: Will Plan Sponsors Believe They’re Lying Eyes or Will They Still Believe Bonds are “Safe”?
Part V: How the ERISA Fiduciary Can Avoid the 3rd Deadly Sin – Bond Insecurity

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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