Investors Pull Out of Bond Funds as Interest Rates Rise
Recent sharp increases in interest rates and the resultant tumbling of bond prices have prompted investors to transfer millions of dollars from bond mutual funds into money-market funds or other funds in the past month, industry officials report.
In contrast, fund officials say, investors transferred relatively little money out of stock mutual funds despite the April 9-14 plunge of more than 100 points on the Dow Jones average of industrial stocks.
The recent losses in bond funds and subsequent withdrawals illustrate the risks being faced increasingly by investors in bonds and bond funds in an environment where interest rates are more likely to rise than fall, some experts say. While the withdrawals from bond funds represented only a small fraction of the total assets in these funds, they are “unprecedented” since the funds gained mass popularity in the early 1980s, said Marshall B. Front, president of the Stein Roe & Farnham group of mutual funds, based in Chicago.
Since 1982, when interest rates have steadily declined, investors in bond funds have enjoyed double-digit gains, thanks to rises in bond prices, since bond prices rise when interest rates fall. But since mid-March, some longer-term bond funds have lost as much as 10% of their value, leading some investors to bail out.
“It dropped like a stone,” Ronald G. Pelligrini, a Beverly Hills property manager, said of two tax-free bond funds that he sold after they lost more than 10% in value since mid-March. “Anybody who bought (bond funds) within the last three months and who is still in them is a for-sure loser.”
“People are not accustomed to seeing steep drops in net asset values of bond funds, but people are aware that equity funds can be volatile,” said Steven E. Norwitz, a vice president at T. Rowe Price, a mutual fund company based in Baltimore. He noted that $200 million was switched out of T. Rowe Price’s taxable and tax-exempt bond funds in the first two weeks of April, compared to only $20 million from equity funds.
A rise in interest rates last summer did not result in a similar spurt of pullouts from bond funds partly because that rise was slower, not sustained and not accompanied by widespread fears about the falling dollar and renewed inflation, as is the case now.
Financial experts, however, said it is unlikely that the latest pullouts will lead to a long-term decline in the popularity of bond funds. A mini-rally in bond prices late last week slowed the outflow, some fund officials say. Also, investors continued to place money into bond funds while others were transferring money out.
Instead, the latest episode is serving as “a warning signal” to many investors that bond funds, particularly those that invest in long-term issues, are risky, said William E. Donoghue, publisher of Donoghue’s Moneyletter, a Holliston, Mass., newsletter. Many investors in bond funds, he said, are unaware that they could lose value.
Lured by yields higher than those of money-market funds, Treasury bills or bank certificates of deposit, investors have poured billions of dollars into bond funds in recent years. Sales of bond and income funds--which invest in dividend-oriented stocks as well as bonds--totaled $161.4 billion last year, three times the sales of stock funds. Bond funds invest in a range of instruments, including such taxable bonds as corporates, Treasuries and Government National Mortgage Corp. (Ginnie Mae) securities, as well as tax-exempt municipal bonds.
But because bonds in the funds carry long maturities, in some cases as long as 25 to 30 years, the principal value--or net asset value--of the funds can decline when interest rates go up. Such a decline can more than offset any rise in yield.
Money-market funds, on the other hand, invest in credit instruments with very short maturities, usually less than three months, and thus carry very little risk of loss of value.
Sharp Drop in Value
With interest rates rising sharply in the past month, losses in net asset value on some longer-term bond funds were large enough to have eaten up several months’ worth of income from their yields. Also in the past month, wealthy investors have been selling tax-free bonds to raise cash for income tax payments. That has depressed prices of tax-free bonds, in turn hurting values of tax-free bond funds.
For example, the tax-free income fund offered by T. Rowe Price has lost 13% of its net asset value since the beginning of the year, with about 9% of that decline coming since the beginning of April. Payments of income from the fund reduced the overall decline to about 7% so far this year.
The Treasury bond fund offered by Vanguard Group, based in Valley Forge, Pa., had declined about 5% in value since the beginning of April. Meanwhile, assets of Vanguard’s prime money-market fund had risen to $2.52 billion as of last Tuesday, a $350-million increase in two weeks. By contrast, the increase in the previous two weeks was only $34 million.
T. Rowe Price’s Norwitz reported that investors are switching money from its bond funds not only into money-market funds, but also into its international bond fund, which invests in overseas bonds. Although hurt by rising interest rates, those funds gain from the falling dollar, which increases the value of foreign bonds relative to U.S. bonds.
T. Rowe Price also reports inflows into its New Era Fund, which invests in stocks of firms in gold mining, natural resources and other industries that stand to benefit from a resurgence in inflation.
Fund officials noted, however, that while the outflow from bond funds is unusually high, it still represents only a small fraction of total assets in those funds. “It’s not a stampede,” Vanguard Group spokesman Brian Mattes said, noting that the outflow from Vanguard’s bond funds has been less than 5%.
Stein Roe’s Front suggested that many investors stayed in bond funds because they care more about the bond’s income than the loss of principal. Others, he said, are longer-term investors who do not want to overreact to short-term events. Still others may be be ignorant of the risks in bond funds.
Downturn Predicted
Whether bond funds continue to lose value depends largely on the direction of interest rates. Many investment experts, pointing to the rally in bond prices last Wednesday and Thursday as interest rates fell back, contend that interest rates have already topped and could go back down again. Thus, investors selling out of bond funds now may be making a mistake, they said.
“The bulk of sales (of bond funds) by individual investors may have occurred at precisely the time they should be buying,” Front said. He noted that Wednesday’s bond rally slowed the outflow from his company’s bond funds.
“It may be too late” to move out of bond funds, said Jay Schabacker, a Gaithersburg, Md., investment adviser and publisher of mutual fund newsletters. His advice to investors uneasy about bond funds is to shift from funds with longer-term bonds into those with shorter maturities.
