Turmoil in the financial sector, stubbornly high energy and food prices and an ailing U.S. economy have sparked a lot of soul-searching in regards to risk management. Put more accurately, investors have flocked in droves to less volatile offerings like money market and bond funds.

It’s true that when you’re looking over your fund account statements, you won’t see the value of your bond funds fluctuate as much as your emerging markets fund. Nonetheless, bond funds do face many risks such as currency risk for global bond funds or prepayment risk for mortgage-backed securities, and of course, credit and interest-rate risk.

When you finance a major purchase such as a home or a new car, the lender looks at your credit score to help determine the risk that you won’t pay your bill on time each month. Armed with that information, the lender decides how much interest to charge you on your loan. The worse your credit score, the higher your interest rate.

There’s a similar process in place when companies issue bonds. Agencies like Dominion Bond Rating Services, Moody’s and Standard & Poor’s rate these companies to communicate their creditworthiness to the investing public. On S&P’s scale, AAA is the highest rating a bond can get, and after that AA, A, BBB, and so on. A bond is considered “junk” if its rating is below BBB. The letter D is the lowest rating a bond can receive and indicates that a bond is in default.

A bond’s rating is not set in stone. The debt rating agency regularly monitors a company’s financial status and can lower its credit rating if it thinks the company’s financials are deteriorating. Lower rated bonds tend to offer higher yields compared with higher-quality bonds to compensate investors for the added risk that they might not be able to make their payments on time.

Generally speaking, higher-quality bond funds make sense for core bond holdings. High-yield bond funds probably work best as supporting players in a portfolio. The basic reason is that investors typically own bond funds to help stabilize their portfolios, not generate juicy returns, and high-quality bonds (and the funds that invest in them) tend to be more stable.

As such, investors should be comfortable with a fund’s credit profile and not just latch on to the fund’s performance. Bond funds with an average credit score of A or better are typically a good place to start for most investors.

A bond fund’s sensitivity to changes in interest rates is another key determinant of its risk level. That’s because bond prices move in the opposite direction of interest rates. When interest rates are falling, that tends to heighten demand (and therefore prices) for bonds with higher coupons. But when rates go up, bonds with smaller yields become less popular than bonds issued at higher interest rates.

You can use a bond portfolio’s duration to get a sense of just how much your fund may lose or gain if interest rates go up or go down, respectively. The rule of thumb is that for every 1% change in interest rates, the value of your bond fund will change by the duration of that fund. For example, if interest rates go up by 1% and the duration of your fund is 5, your fund will decrease by about 5%. So the shorter the bond duration, the less it will be affected by a change in rates.

It’s important, though, to distinguish between bonds and bond funds. If you’re a bondholder and rates go up, you don’t lose money unless you try and sell your bond on the open market. On the other hand, bond funds could experience losses if underlying securities are sold prior to their maturity date.

A less obvious risk is the eroding effects of inflation. Most bonds pay interest on a principal amount that is fixed. When the bond reaches its maturity date, the principal is repaid to investors. But thanks to inflation, this amount won’t be worth as much in real dollars as it was when you first invested it.

One solution to this dilemma is to invest in real return bond (RRB) funds. Basically, the principal amounts of RRBs are adjusted to reflect the rate of inflation at maturity, as are their periodic interest payments. So all else being equal, the value of the investment is protected from the ill effects of inflation.

Another risk that is often overlooked is fees. Over the long term, bond offerings have generally returned less than equity funds. It only makes sense then that bond funds should cost less, and for the most part they do.

However, investors paying a 2.25% management-expense ratio for their equity funds shouldn’t think they are necessarily getting a good deal by paying 1.75% for a bond fund. With a much narrower range of returns in most bond fund categories, expense ratios rather than skilled management often separate the successful from the underachiever.

Indeed, funds with low expense ratios boast a nearly insurmountable advantage over their highercost rivals, while those with average to above-average costs often struggle to stand out. A quick look at the five-year return rankings in the Canadian Fixed Income category illustrates that point. Of the 22 funds that rank in the category’s top quartile, over two-thirds boast MERs below the category median of 1.47%. On the flip side, only two of the 20 funds in the bottom quartile sport a below-median MER. Coincidence? We think not.

Jordan Benincasa is a fund analyst with Morningstar Canada.

Originally published in Advisor's Edge Report