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By Christine Benz and Eric Jacobson | 05-22-2013 12:00 PM

4 Hidden Risk Factors in Bond Funds Today

Investors should dig into their bond portfolios to understand all the places their managers are hunting for yield, says Morningstar's Eric Jacobson.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

With the prospect of higher interest rates looming large, many investors are naturally attuned to the risks that could be lurking in their bond portfolios.

Joining me to discuss some hidden risks in bond funds today is Eric Jacobson. He is a senior mutual fund analyst with Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Hi, Christine. Great to talk to you.

Benz: Eric, let's start by talking about one risk factor that probably very few fund investors saw coming, and that's the fact that some bond funds are actually buying stocks these days.

Jacobson: That's right. The numbers aren't actually that great in terms of the number of funds. There are only about 40 of them in our database, for example, that have more than 5% of their assets in stocks. But if you own one of those funds, it certainly can change the flavor of your portfolio.

Benz: So, let's talk about the types of bond funds that would be most likely to have equity exposure. Would I find it in, say, my general bond fund, or would I have to have something a little more specialized?

Jacobson: It does pop up in a few generals, what we might think of as core bond funds, but more frequently you'll see it in funds that tend to be a little bit riskier by design, such as multisector bond funds or high-yield bond funds.

Benz: Well, let's just discuss why this would be a risk factor. What's the problem with this?

Jacobson: The biggest risk is that, as most people know, stocks just tend to be more volatile than bonds. We've got a lot of fear out there, obviously, right now about rising interest rates. But even if you go back and look at 2008 and the worst of things that happened, even bonds with considerable risk outside of interest rate risk still performed better than the equity markets did, and certainly bonds with a lot of interest rate risk, such as Treasuries, actually performed very well during 2008 and provided that kind of diversification ballast. The more you venture into stocks inside of a bond fund, the more you may tilt the flavor of that fund away from the bond market.

Benz: Let's talk about another potential risk factor, Eric, and that's the potential for bond funds to be holding foreign bonds. First, I'd like to discuss, is that a risk factored at all. So, for example, if my fund has some foreign bonds, will those bonds necessarily be more risky than U.S. bonds?

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