The answer has to do with the fact that bonds have a fixed rate of return, the interest rate. A $10,000 bond issued with a 5% interest rate (sometimes called a coupon) has an annual rate of return of 5% if held to maturity. However if the prevailing market interest rate (the 10 – year U.S. Treasury is the most widely used standard) increases then the value of the 5% return on our bond becomes less valuable. If we must sell the bond before maturity buyers will be willing to pay us less for it. Fortunately, this is a two edged sword and if prevailing market interest rates decrease the value of our existing bond will increase, and buyers will be willing to pay more for it. It is important to realize that as long as we hold our bond to maturity and the credit quality of the bond is good, the bond will be redeemed at its full value and we will get our principal back and realize the full 5% return no matter what has happened to interest rates in the meantime. The price changes however are reflected in the statements that investors receive from their custodians or brokers and these may cause some concern.
The risk that bonds may decrease in value when interest rates rise is called interest rate risk. Even though we are in an environment where interest rates are generally believed to have to rise over the next few years, most investors, including large institutions like pensions and insurance companies have no choice but to own bonds. Most investors must own bonds not only to produce income, but to buffer the much greater volatility on the stock portions of their portfolios. There are ways to reduce the interest rate risk in your portfolio. I would encourage you to make an appointment with a fee-only investment advisor to discuss options.
Bond mutual funds offer a unique problem for bond investors as there is no maturity for a bond fund. A bond fund is a portfolio of individual bonds. Hence the price of the fund fluctuates with market interest rates and reflects the individual price fluctuation of the bonds in the portfolio. There is an added problem with bond funds (and this represents the major drawback to using bond funds for fixed income investing) in that investors tend to pull money from bond funds in a rising interest rate environment as they see bond prices falling (and the value of their fund shares decreasing). These withdrawals may cause the fund manager to sell bonds in order to meet redemptions, removing the option to simply hold the bonds to maturity.
There are, however, advantages to using bond funds (particularly for small investors). Most importantly bond funds give you access to professional management and we have found that there is some talent out there in the bond area that is worth the additional cost over and above using an index. Bond managers have expertise in credit quality analysis and risk management that is very difficult for individual investors (even large ones) to duplicate. Both of these skills are essential in the management of bond portfolios. Diversification and pricing on bond purchases are also important advantages that bond funds offer. We constantly preach the value of diversification when investing and a bond fund that may own thousands of bonds from different issuers is obviously better diversified than an individual investor who owns only a few. It is also important that bonds are typically bought and sold without commission on a mark-up basis (the broker sells it for more than they paid for it). Standard industry trading blocks are $1,000,000, any block of bonds smaller than that will have a larger mark-up and hence be more expensive to acquire. Small investors buying very small blocks of bonds ($1,000 to $20,000) are paying very high mark-ups to acquire bonds and there for will have lower income from the bonds. Additionally, large buyers like mutual funds are able to acquire bond issues that are only sold to large institutional buyers; these private issues are never offered on the retail market. Finally, large institutional buyers have access to and expertise in areas of the fixed income markets that retail investors do not, typically these areas include foreign bonds, emerging markets bonds, and mortgages to name just a few. Essentially we believe that for individual investors the advantages of bond funds far outweigh the disadvantages and offer value when used properly and in most 401(k) plans they are the only option.