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Bond Funds Revisited- Risky Business?

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Last fall I posted Bond Funds – Safe Haven or Risky Asset? The post was prompted by the massive influx of dollars into bond mutual funds. This trend continued through the end of 2009 when inflows into bond mutual funds reached a record $396 billion.

This was likely prompted by several factors:

Low yields on money market funds

Bonds outperformed stocks for the decade just ended

Tremendous returns for bond funds in 2009, the average bond fund gained 17% with many posting far better results

Bond funds can be volatile, however, as we learned in 2008. The management team running Loomis Sayles Bond Fund was selected as Morningstar’s Fixed Income Manger of the Year for 2009. The institutional share class of the fund gained over 37% in 2009, an astounding return for a bond fund and almost 8% above the average muti-sector bond fund in the Morningstar universe.

Going back a year, the fund lost almost 22% in 2008, an equally astounding loss for a bond fund.

The losses in 2008 for Loomis Sayles and most other investment grade bond funds were due to an aversion to anything carrying more risk than a Treasury in the last quarter of 2008. Credit worthiness and low interest rates didn’t matter. Nobody wanted to take ANY credit risk.

The appetite for risk and a stretch for yield returned in 2009. Stung by the performance of their stock investments in 2008 many investors turned to bond funds in the hope of better than cash yields with lower risks than stocks.

Bond funds face risks going forward from two sources:

Rising interest rates. With rates at historic low levels, mounting levels of government debt to finance, and the normal rise in interest rates that comes with an economic recovery there will pressure on interest rates to rise over the next few years. Rising interest rates, all else being equal, result in lower prices for existing bonds and bond funds.

The prospect of inflation. Many think inflation will return as the economy heats up and the full impact of the government’s stimulus programs ripple through our economy. Inflation is the enemy of bond investors because of the fixed nature of bond interest payments. In a period of rising inflation, these fixed payments lose purchasing power to inflation over time.

I am not advocating that investors avoid bond funds or sell off their existing bond fund holdings. Rather, I want to point out the potential risks ahead for bond funds. The year just ended was a year of recovery and relatively easy gains for bond fund investors. The coming years may well not provide opportunities like 2009.

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Comments

  1. As you know, Roger, this is as much an issue of Investor Behavior as it about investment selection.

    Despite all the resarch from Dalbar and even Morningstar, it's amazing to see investors do the wrong thing at the wrong time over and over again – whether with stocks, bonds, bond funds or any other investment vehicle.

    It is this cycle of emotional decision making that makes it such a challenge for most people to manage their own finances without the help and guidance of a professional like you.

  2. Russ thank you for the comment. Over the years we both have seen investment dollars chase performance with often unhappy results. The current environment of low interest rates and the prospect of longer-term inflation makes investing in bond funds potentially very risky. I hope we do not see investors looking for yield and relative saftey get burned once again for investing at the wrong time.

  3. Perfect timing – huge inflows like this have a significant correlation to market tops and bottoms.

    As you mention, the Treasury Department is bringing record new bond supply to market in 2010. China, the largest buyer of U.S. bonds, has been reducing their purchases and if this continues it forces more supply on American investors…and possibly at lower prices.

  4. Roger, you're spot on as usual. Trouble is, I think most professionals know this. If this is correct, are these mostly non-advised retail investors going into the bond funds?

  5. So where do I go for my "fixed income" component…this has been beating me up. Dividend stocks? Corporate debt?

  6. Ari thanks for your comment. As I mentioned in the post I'm not advocating that investors get out of or avoid bond funds, only that they understand the potential risks, especially if they are committing new money.

    There are any number of ways to do a fixed income component, but the first determinant should be how this component fits into your overall financial plan.

    Adding dividend stocks over and above your normal equity allocation adds equity risk to your portfolio.

    As far as fixed income you can do things such as a ladder of individual bonds or CDs. You could shorten up on the duration of the bond funds you use. Corporate debt, especially lower quality debt, might be less susceptible to rising rates due to higher yields. Buying individual issues here might not be feasible, so a fund may be the way to go. However there are risk considerations here as well.

    There are also several alternative mutual funds which I have used as "bond substitutes" over the years.

    As I don't know your inidividual situation I can't provide more specific guidance but hopefully this will give you some food for thought.

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  1. […] Safe Haven or Risky Asset thinking that interest rates were headed up in the near future.  I wrote an update of this post in January of 2010 under the same premise.  This illustrates why I refrain from predicting […]

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