Investors are scrambling and yanking billions from US bond funds since the Federal Reserve rattled markets with its plan to end the central bank’s unprecedented asset purchase programme. According to research firm TrimTabs Research, mutual funds and bond exchange-traded funds saw a combined $47.2 billion in fund outflows during June. This was biggest monthly outflow on record, even exceeding October 2008. Retail investors who have put approximately $1 trillion into the perceived safety of bond funds since the beginning of 2009 have started to reverse this trend. Most investors are not used to seeing losses in bond exchange-traded funds (“ETFs”) or fixed income mutual funds as bonds have been on a thirty year bull run and the last negative returns were seen in the 2008 financial crisis. The Pimco Total Return Fund, a sort of flagship bond fund, has fallen over five percent in two months, slightly worse than the Merrill Lynch US Corporate Index of about five percent.The iShares iBoxx Investment Grade Corporate Bond ETF, has posted a two month loss of 6.36% and the Vanguard Total Bond Fund has lost 3.54%. The ten year Treasury yield has soared over 100 basis points or one percent since the beginning of May and the iShares 20+ Year Treasury ETF has been thumped 9.8%. For bond ETFs and funds, rising rates mean that interest income is fighting losses of holdings in the underlying portfolio due to higher interest rates. As the fund’s net asset value or NAV declines, the coupon interest it receives may not be enough to overcome the price loss. Constructing a portfolio of higher quality bonds, holding them to maturity and laddering maturities is a far superior strategy that can protect principal and avoid losses in some ways bond ETFs and funds are unable to do.Tailored Individual Bond Portfolios versus Bond FundsLet’s first contrast and compare bond funds and individual bond portfolios. In a bond fund, if interest rates rise the price of the principal holdings in the fund fall. If the interest income the fund receives is not sufficient to cover this loss in principal for the period, the fund’s return is negative for the period in question. Bond fund investors are making a call on interest rates much like stock market investors make a call on the stock market when they invest in stock funds. Bond funds have no legally mandated maturity date or obligation to return principal. The investor chooses when to redeem and at what price. This fall in net asset values can have a substantial negative impact on the portfolio if clients need to make withdrawals. If you hold individual bonds to maturity, however, and assuming they do not default, you will receive scheduled coupons and a return of principal. There price will fall, like those bonds in funds, but if the portfolio’s maturities correspond with liquidity needs, no forced selling at depressed prices is necessary.Unlike more widely used bond funds, individual bonds offer predictability when managed properly. A rise in rates is not a concern for an owner of individual bonds that are held to maturity and that match cash flows needed and insulates clients from volatile markets. It only becomes an issue if they wish to sell before maturity because of liquidity needs, credit issues or fundamentals.Holding a portfolio of individual bonds allows one to tailor a portfolio to manage interest rate, market risk, as well as match liquidity needs. It does, however, require one to analyse credit risk of each and every position. An investor should ensure he/she has sufficient funds to invest amongst a variety of positions to ensure sufficient diversification. Bond funds or ETFs, offer instant diversification but you are being pooled with all other investors.You will be subject to the flows of those investors and the mandate of the fund itself. For example, if everyone “panics” and sells at the same time, the fund will likely fall in value and may force you to redeem at a lower price than desired at periods when cash is needed.What Does Happen If Rates Rise?Stephen Huxley, the chief investment strategist at Asset Dedication and a professor of analytic modeling at the University of San Francisco, conducted a study on the effects of rising rates on bond funds.In the period from 1950 to 1981, several negative return years and a total return of 2.2% caused an intermediate-government bond index (a common bond fund index) to lag individual bonds. He found that individual bonds returned on average 5.6%, or 3% more compounded over 31 years. This of course adds considerably to returns $10,000 invested at 2.2% compounded yields 19,633 in 1981, while compounded annually at 5.6% yields an ending value of $54,148 or 2.75 times more money!Crestmont Research has also done an exhaustive study on individual bond ladders.Their research has found that:“This analysis of historical interest rates shows that simple bond ladders, particularly maturities of ten years and less, did not experience annual losses anytime over the past century. A simple bond ladder may be one of the best approaches for fixed income investing as the potential for rising rates looms. A bond ladder is a portfolio of bonds with a portion of the portfolio maturing each year (often equal amounts across each annual maturity).”The key is to build a “dedicated bond portfolio”. This requires synchronising the bond maturities and coupon payments to match the cash flow stream of the individual, then holding the bonds until they are redeemed.The past 30 year bond bull market which has been accompanied with ever lower interest rates may be coming to an end. Unfortunately this period may have masked some of the hidden risks embedded in fixed income fund structures for retired clients in withdrawal portfolios. The last couple months may have shown investors the vulnerability of a rising rate environment to these funds. This is not a call to rush out and liquidate all bond funds. For some they will not have sufficient capital to adequately purchase a diversified substitute. I would consult your financial advisor, however, and see what would be a more effective strategy for you or your company.Nathan Kowalski can be contacted at nkowalski@anchor.bm or 296-3515Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Anchor Investment Management Ltd to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisors prior to any investment decision.