May 30, 2013 / 6:43 PM / 4 years ago

COMPLY-Preparing clients for looming bond risk

NEW YORK, May 30(Reuters) - Brokers who fail to warn their clients about the risks of bond investing may find themselves facing regulatory ire and legal actions in the future, compliance experts say.

The Financial Industry Regulatory Authority is sounding alarms about the possibility of plunging bond values as the economy recovers and interest rates rise. Investors who have been buying bonds because they offer higher yields than guaranteed bank certificates of deposits may not be aware that they could lose money in a rising-rate environment, the Wall Street watchdog said.

"It is clear that interest rates have far more room to go up than down," said Richard Ketchum, FINRA's chairman and chief executive, at the regulator's annual conference in Washington last week. His comments followed an alert from the self-regulatory organization to investors in February about fixed income risks.

A rise in rates would lead to falling bond prices that could result in steep losses for investors, especially those who overconcentrate their portfolios in long-term bonds and the mutual funds that hold them. It could also mean headaches for brokers years from now, including arbitration complaints from angry clients, say lawyers.

Investors poured $301 billion into U.S.-registered bond funds in 2012 and have added another $121 billion through April of this year.

Investors continue to be attracted to fixed income investments like bonds, notes and bills because they perceive them as safer than stocks.

But with many people suggesting that the three-decade bull market in bonds is over, it is a "great time" to have conversations with clients about the negative outcomes those investments may spur, Ketchum said.

TOO YOUNG TO REMEMBER THE PAIN

Many advisers and their clients have not lived through a major bear market in bonds - one in which values plummet 20 percent or more, said Mary Ann Bartels, chief investment officer of portfolio strategies for Bank of America's Merrill Lynch unit .

Merrill and its sister Bank of America subsidiary US Trust are re-educating advisers and clients about the pitfalls of fixed income investing and how to hedge against those risks. TD Ameritrade, a unit of TD Ameritrade Holding Corp, began ramping up its website content about the risks of rising interest rates in January.

The conversation, however, is more nuanced than pulling out of the bond market entirely.

"You don't want to take away fixed income securities," Bartels said. "You want to manage them."

There are some investment strategies that can minimize risks, but advisers can't afford to simply leave their clients' bond holdings on autopilot. Independent registered investment advisers (RIAs) are required to recommend securities that are in their clients' best interests.

And a recent change to securities industry rules requires that broker-recommended investments be suitable for clients at all times, not just when they are purchased. So bond funds that were bought a year or two ago may no longer be the right choice for a period of impending rate hikes.

Documenting recommendations, including hold strategies, could spare brokers considerable angst if clients file arbitration complaints years from now, say lawyers.

ARE BONDS SAFE?

Financial advisers face the common misconception that bonds are risk free. Clients tend to think only of the steady interest payments they receive, but not the risk to their principal, said David Edwards, president of Heron Financial Group LLC, a New York-based RIA.

Investors do not often anticipate having to sell their bonds before a far-off maturity date, but fixed-income investments sold early could be worth less than face value if rates rise, Edwards said. A person who invested $10,000 in 10-year U.S. Treasury notes would see her principal fall by roughly $1,000 if rates rose by 1 percent.

This is a stickier problem for people who buy bonds through mutual funds, because those funds don't ever mature. A person holding an individual bond can still get her $10,000 back if she waits until the bond matures. But a person investing $10,000 in a bond fund would never know when the fund's prices would recover from rising rates.

Another risk that investors don't always grasp: inflation rates could outpace interest income from the bond, causing bondholders to lose purchasing power.

STRATEGIC APPROACHES

Advisers at Baron Financial Group have trying to reduce those risks by exerting more control over clients' fixed income assets, said James Shagawat, a principal at the Fair Lawn, New Jersey-based wealth management firm.

Shagawat invests clients' fixed-income assets in high quality individual bonds, such as AAA-rated corporate and municipal bonds, instead of mutual funds that can include hundreds of bonds with varying maturity dates.

Shagawat typically "ladders" bonds for clients - a strategy in which clients buy bonds with different, but evenly spaced maturity dates to help offset risks of rising interest rates.

Merrill and U.S. Trust are reviewing client portfolios to reassess fixed income risks, according to Liam O'Neil, head of Merrill's Global Wealth and Retirement Solutions Markets Group.

That takes their outreach to clients beyond simple risk disclosure, concedes Bartels: "You can give them all the education, but they will still be reluctant to change." (Editing by Linda Stern; Desking by Bernadette Baum)

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