Some Bond Fund Buyers May Need to Rethink
Stock mutual funds are attracting the bulk of fund investors’ new dollars this year, right?
Not right.
As hot as stock funds have been, investors have poured almost $20 billion more this year into income-oriented funds such as bond and money market funds.
Net new cash flow--new purchases less redemptions and exchanges--into bond and money funds totaled $126.2 billion through May, while stock funds’ net new cash flow in that period was $106.5 billion, the Investment Company Institute reported this week.
By contrast, in the first five months of 1997, stock funds took in $92 billion, more than double the $41 billion that flowed into bond and money funds.
While the bulk of this year’s income-fund cash flow ($83 billion) has gone to money funds--which function as checking accounts for some investors, and thus aren’t necessarily considered investments--bond funds still are more popular these days than at any time since the mid-1990s.
And why is that?
The conventional wisdom is that many investors are pumping money into bond funds to hedge their bets on the high-flying stock market.
Bonds, after all, pay a set rate of interest and thus are viewed as far less risky, overall, than stocks, whose value today depends far more on investors’ collective mood swings than on any cash dividends the shares may pay.
So if the stock market dives, many investors may be figuring, the price of their bond fund shares should hold up reasonably well. Hence, a hedge.
That isn’t a bad assumption with most bond fund categories. But there’s a problem here: The most popular bond fund category in recent years has been “junk”--funds that own high-yield corporate bonds issued by companies considered less than investment grade.
And junk bonds, historically, have not been a good place to be invested if the reason the stock market is falling is because of worries about the economy’s health.
Data from the ICI show just how hungry investors have been for junk bond funds in recent years, versus for other bond and income fund categories:
* From 1996 through May, junk funds took in net new cash flow of $38.98 billion, the ICI says. The funds’ total assets as of May 31: $120 billion.
* Strategic income funds--a category that includes so-called multi-sector funds that also usually invest heavily in junk bonds--took in $23.49 billion over the same 29-month period.
* Meanwhile, funds that own long-term U.S. government bonds have seen cash flow out rather than in. A net $11.18 billion has been pulled from those funds since 1996, reducing the category’s assets to $35.5 billion, ICI says.
* Likewise, investors have on balance yanked cash from mortgage-backed bond funds, such as those that invest in Government National Mortgage Assn. bonds. Those funds have seen $9.87 billion flow out since 1996.
The trends beg the question: Are bond fund buyers simply going for the highest-yielding funds, rather than choosing the most appropriate type of bond hedge for their total portfolios?
Fund company executives concede that there has been a “reach for yield” on the part of many fund investors. “I think yield continues to drive fixed-income fund sales, as it has for some time,” said Edward D’Alelio, chief of corporate fixed-income for fund giant Putnam Investments in Boston.
Junk funds now boast annualized yields of 8% or higher, while long-term U.S. government funds yield between 5% and 6%.
Still, D’Alelio believes that most bond fund buyers are basically on the right track in seeking to diversify their portfolios, which may have become excessively stock-heavy in the wake of Wall Street’s unprecedented three-year surge.
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What’s more, the outflows from government-bond funds may not indicate that investors are abandoning those securities, experts say. Rather, because Treasury securities can easily be purchased individually--and held to maturity, with no risk of loss (Uncle Sam always pays his debts)--many investors may be going that route instead of buying government-bond mutual funds, analysts note.
Still, experts caution that if the economy should start to slow significantly--raising the risk of a surge in defaults by junk-bond-issuing companies--investors who thought they had a good hedge for their stock portfolios might discover instead that their junk bond funds are sinking with stocks.
That was the case in 1990, when the last recession began. The average stock fund fell 6.3% that year, according to Lipper Analytical. But the average junk bond fund fared even worse, posting a negative total return of 11.1%--which means that junk bond principal values fell so far that year they more than wiped out the interest earned on the majority of junk issues that didn’t default.
There’s a good argument that that year was an anomaly. The junk market was untested by recession before then. And the collapse of brokerage Drexel Burnham Lambert--the leading purveyor of junk issues--sent a shock wave through the entire junk market.
The junk market’s rebound in 1991--when the average junk fund posted a total return of 36%--showed that junk bond prices had fallen to absurdly low levels.
And since then, junk bonds have performed stellarly. The average total return on junk funds in the five years ended March 31 was 67%, versus 32% on long-term U.S. government bond funds. So investors took more risk in junk bonds, and they’ve been rewarded.
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But in the second quarter of this year the average junk fund posted a slightly negative total return, while most bond fund categories posted positive returns, according to Lipper. That means junk yields have been rising in the marketplace, depressing the principal value of older junk bonds.
Why have junk yields gone up, even as Treasury yields have fallen? Because investors are judging that “the risk associated with owning low-rated bonds has to be rising,” said Tad Rivelle, a bond manager at Metropolitan West Capital in Los Angeles.
That isn’t surprising, given the global market turmoil in the first half of the year. Worries about Asia, falling commodity prices and the general weakness in smaller companies’ stocks all have weighed on the junk bond market, because any one of those negatives could affect highly leveraged companies with junk bonds outstanding.
Ben Trosky, junk-fund manager at PIMCO funds in Newport Beach, says that with the U.S. economy slowing, the junk market in coming months “might even start factoring in a recession,” when defaults would surely rise.
That doesn’t mean junk bond values are on the verge of collapsing. But Trosky describes himself as “cautious” on the market, and unwilling to hold the riskiest junk bonds, even at much higher yields.
The message here for individuals in junk funds isn’t necessarily that it’s time to sell. But it is time to ask why you own this type of fund. If what you want is a hedge against a stock market plunge, a government-bond, municipal bond or high-quality corporate bond fund might be where you belong--even if that means earning a lower yield.
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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com
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Bonds, Yes. But What Kind?
Individual investors have been buying bond mutual funds at an increasing pace during the last two years. But they are mostly reaching for the highest-yielding bond funds, while shunning U.S. government-bond funds. Net new cash flow of key bond fund categories, 1996 through May, in billions of dollars:
High yield: +$38.98
Strategic income: +$23.39
Intermed.-term corporate: +$17.75
Global: --$4.34
Mortgage-backed: --$9.87
Long-term government: --$11.18
Source: Investment Company Institute
