S ometimes a bond is not a bond.

It’s been brewing for a while. Should 401k plan sponsors keep bond funds as investment options or replace them with something that more accurately describes the risks of such investments. Traditionalists argue to keep bond funds because they’re a traditional asset class. Modernists say while bonds are indeed a traditional asset class, bond funds are really equities and including them as an option labeled “bond” anything misleads 401k investors. To date, the argument has remained on par with how many angels can dance on the head of a pin. It’s a debate for purists only, as practitioners and investors have experienced returns in their bond funds that have put some equity funds to shame.

That might be about to change.

As any good economist knows, as long as our economy continues to stagger, rates can remain at historic lows. But any hint of growth arbors a prelude to rising rates. There are some that feel this scenario is right around the corner. Since many of our readers are fiduciaries and are rightfully more concerned with worst case than even the likely case, for the sake of argument let’s set aside this economic debate and focus on these concerns.

Here’s the problem in a nutshell. As the economy improves, the need for the Fed to keep rates low diminishes. In fact, during economic booms, the Fed often raises rates to keep inflation from overheating. Would the world be that good. Suffice it to say many expect an improving economy to lead to higher rates. “Rising interest rates translate into lower prices for existing bonds,” says Chuck Epstein, a Massachusetts-based communications consultant and author of How 401k Fees Destroy Wealth and What Investors Can Do To Protect Themselves . He adds, “The reason is that in a rising interest rate environment, newly-issued bonds will carry a higher coupon rate. This acts to depress prices on previously issued bonds as market demand switches to bonds carrying the higher coupons. In 401k plans, bond funds should be offered with specific education about the fund’s investment goals, fund holdings and maturity. This is especially important since rising rates have a greater impact on longer maturity bond funds.”

Just how different are individual bond from bond funds? “While the value of an individual bond may fluctuate based on changes in interest rates, the bond holder is guaranteed to receive the return of his principal if he holds the bond until maturity. Bond funds, on the other hand, cannot guarantee the return of the investor’s principal, as there is no ‘maturity’ as such and prices can fluctuate based on interest rates and other issues regarding the quality of the bond,’ says James W. Watkins, III, CEO/Managing Member of InvestSense, LLC in Atlanta, Georgia.

The idea of “preserving capital” is not the only thing lost in the translation from bonds to bond funds. Investors also lose the advantage of “fixed income.” Rich Winer, President of Winer Wealth Management in Woodland Hills, California, says, “When you purchase individual bonds, you are guaranteed a specific interest rate until maturity. When you purchase a bond fund, you own a managed portfolio of bonds. When you own a bond fund, you are not guaranteed any particular interest rate.”

Because interest rates are virtually zero right now, it may not matter if you own a bond or a bond fund. “As interest rates rise, the bonds that bond funds own become worth less. That’s the risk,” says “Bo Lu, co-founder and CEO of FutureAdvisor in San Francisco. Adds Hilary Martin, MBA, Financial Advisor at The Family Wealth Consulting Group in neighboring Silicon Valley, California, “If you own a bond or a bond fund now, over the next year there will be no difference – your returns will be the same.”

Individual bonds, however, do retain a significant advantage over bond funds. “If you’re holding the individual bond, you can always choose to not sell and just hold it to maturity. If you own a bond fund, this is not a choice you can make,” says Lu.

In fact, without the promise of a fixed income and capital preservation, bond funds begin to sound like dividend-oriented stock funds. “Bond funds are pooled investment vehicles. As a result you don’t have the luxury of holding an individual bond to maturity that would mitigate capital loss from interest rate changes. Instead, the bond fund will rise and fall inversely to interest rate changes causing permanent capital gain or loss,” says Todd R. Tresidder, Founder and Financial Coach at FinancialMentor.com in Reno Nevada.” Tresidder continues, “In simple terms, a bond fund has a different risk profile than individual bonds. When you combine higher volatility risk with reduced interest income you have risk characteristics that can be compared with stocks.”

“The drawback in bond funds is that income distributions and fund values fluctuate as market conditions change,” says Epstein, who adds, “In a rising interest rate environment, investors should be alert to shortening the duration of their bond funds, including a move into money market funds for very conservative investors.”

Given this volatility, the kind of unexpected surprise many retirement investors fear, do bond funds continue to merit inclusion in the menu of a typically 401k plan? Lu recommends stable income funds for 401k plans “especially if it’s available in a low-fee instrument.” Winer would not normally recommend a stable value fund, “except as an alternative to a money market fund if the interest rate is higher.”

With the inevitable rise in interest rates coming, some advisers have taken a more measured approach regarding the appropriateness of using bond funds. “Bond funds still make sense for many investors, even with interest rates expected to rise,” says Michael T. Prus, President of Scale Investment Group, LLC, which has offices in both White Lake and Grand Blanc, Michigan. “It’s not necessarily a case of shunning bonds entirely,” he adds, “but picking less interest rate sensitive bonds or shortening duration on the fixed income portion of the portfolio. With that said, some investors may be less willing or able to withstand the fluctuations changing interest rates would have on bond prices. These investors should be invested in some combination or short or ultra-short fixed income and stable value/cash to minimize principal fluctuation to an acceptable amount.”

We end with this comment from Timothy R. Yee, Co-founder of Green Retirement Plans in Oakland, California, who reminds us, “I suppose all types of funds could be affected by rising rates.” Indeed, changing rates can impact interest rate sensitive equity sectors like banks and real estate, just as much as they can impact bond funds. But, maybe that’s the whole point. Perhaps a bond fund has characteristics more closely aligned with these equity sectors than with the individual components within the very bond fund.

And, if that’s the case, how does the 401k plan sponsor explain that to the unsophisticated employee?

Sometimes a bond is not a bond.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the “one portfolio” concept (as well as leaving room for those few remaining do-it-yourselfers).

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