Bond Funds Still in Shadows Despite Their Bright Year

By TOM PETRUNO

Dec. 10, 2000 12 AM PT

Individual investors often are accused of chasing performance--that is, piling into whatever market sector has been hot in the immediate past.

That’s a problem the bond mutual fund industry would love to have this year.

High-quality bond funds are on track to turn in their best performance since 1995. And barring a dramatic stock rally between now and year’s end, the average bond fund will outperform the average stock fund this year for the first time since 1990.

Yet investors, on balance, have continued to yank money from bond funds all year. Through October, a net $32.6 billion has poured out of taxable bond funds, a category that includes government-bond and corporate-bond funds. A net cash outflow is the excess of investors’ redemptions from funds over new purchases by other investors.

Tax-free municipal bond funds, the biggest stars in the bond fund universe this year in terms of gross performance, also have failed to attract new money, on balance: The year-to-date net cash outflow from muni funds through October was $15.7 billion, according to the Investment Company Institute, the funds’ chief trade group.

Those net outflow figures aren’t a pittance compared with the total assets of these fund sectors. For both taxable and tax-free bond funds, the outflows so far represent about 6% of each category’s assets at the start of the year.

You can imagine how it feels to be a bond fund manager this year. While the average stock mutual fund is up a mere 0.6% year to date--and technology-stock funds have lost 20% or more--many bond funds have produced total returns in the vicinity of 10%. So bond funds have played their traditional role as a relatively safe haven for investors’ capital in times of market turmoil.

Yet stock funds, on balance, still are taking in net new cash (a record $291 billion for the year, through October), while bond funds’ reward for making money this year is net redemptions.

There are some good reasons many investors remain unappreciative of bond funds, which we’ll get to soon. Still, those who believe bonds are unnecessary, unexciting or simply uncool in the context of a diversified investment portfolio may want to reconsider in the wake of this year’s performance results and what those results may portend for this decade.

Investors who were around in the 1980s remember that it was a great decade for stocks, beginning in 1982. Yet bond funds far out-classed stock funds for most of that decade in terms of total assets.

From 1984 through 1990, bond fund assets ballooned from $46 billion to $291 billion. In that same period stock fund assets rose from $83 billion to $240 billion.

Fund investors liked bonds because the returns were spectacular. The 1980s started with record high interest rates to match the record-high inflation of that era. But as inflation came down in the ‘80s, so did interest rates, including on bonds. That generated tremendous total returns on bonds.

What, exactly, does “total return” mean?

Say that, in 1982, you bought a fixed-rate, 10-year bond that paid 13% annual interest. So you were assured of earning that 13% a year until the bond matured, unless the issuer defaulted.

As yields on newly issued bonds fell in the ‘80s, your 13% bond naturally became more valuable. Thus, its market price rose, generating a principal gain that was gravy atop your already-handsome yield.

In the 10 years ending Dec. 31, 1990, the average bond mutual fund that owned high-quality corporate bonds produced a total return of 210%, according to Lipper Inc. That topped the 202% return on the average stock mutual fund in that period. No wonder investors loved bond funds.

In the early 1990s, as market interest rates continued to fall, the number of bond mutual fund accounts continued to zoom, even as stock fund accounts surged, too.

But everything changed in 1994, when the Federal Reserve began to tighten credit dramatically, causing short-term interest rates to double and sending long-term rates up as well.

Investors who had piled into bond funds learned that “total return” in the bond market cuts both ways: If you’re holding a long-term bond yielding 6%, and newly issued bonds yield 8%, your older, lower-yielding bond obviously is going to be worth less in the market.

So the bond’s principal value falls, which is subtracted from whatever interest you’re earning on the bond to show your net, or total, return.

Note that it isn’t a question of getting the interest that’s owed to you--you still earn that. And if you don’t sell your bond, or bond fund, you don’t officially have a principal loss. But it’s there, nonetheless, in this case; total return tells you what you truly have earned, or lost, on a bond, interest earnings and principal change combined.

Many investors who bought bond funds in the early ‘90s clearly didn’t understand the idea of total return. They thought bonds never lost money. But if market interest rates are rising, bonds can indeed lose money, at least on paper.

Which brings us, round-trip, to this year. Once again, yields on high-quality long-term bonds, including U.S. Treasury issues and tax-free municipal issues, have fallen as the economy has slowed. That has boosted the principal values of those bonds, making for the 10%-or-so total return on many long-term bond funds year to date.

Why, then, are investors pulling money out of bond funds?

The fund industry has been vexed by this question. There are, however, some reasons for the net cash outflow that make good sense.

For one, some investors are opting to own individual bonds--say, a 5-year Treasury note purchased directly from Uncle Sam--rather than bond funds. With an individual bond, you know exactly what you’re going to earn in interest, and you know that when the bond matures you’re going to get the stated maturity value back in full.

Bond funds, by contrast, can’t guarantee a set interest rate (though they try to keep their yields relatively steady), and their share values are at the mercy of market interest rate trends. You can’t predict what your fund shares will be worth in five years.

Many investors also are comparing yields on bonds with what’s available on short-term accounts, such as money market mutual funds, and understandably don’t see the immediate appeal of bonds.

A 10-year Treasury note now pays 5.30% a year, while a money market fund yields about 6%. Why not just own the money fund?

There is, in fact, just one reason to go with longer-term bonds now: You have to assume, as do many Wall Street pros, that the Federal Reserve will be cutting short-term rates in 2001. If that happens, many people may wish they had locked in longer-term yields.

Investors who have long-term savings in retirement accounts, and who are debating whether to make changes in that asset mix for 2001 and beyond, should pay particular note: Over 10 years, odds are that longer-term bonds will return more than short-term accounts.

But will bonds earn more than stocks? Over time, probably not. If the idea of capital preservation suddenly means more to you amid this year’s wild stock market, however, it’s worth looking into bonds as part of your investment mix: With bonds, interest is always accruing; with stocks, capital gains aren’t guaranteed.

Tom Petruno can be reached at tom.petruno@latimes.com.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Bonds: Performance Doesn’t Matter?

Bond mutual funds of nearly all types have posted strong returns this year, especially compared with the stock market. Yet bond funds overall have suffered net cash outflows, at least through October.

Good Returns ...

Year-to-date average total returns by bond fund category, through Thursday (interest earnings plus or minus principal change):

Long-term U.S. govt.: 10.8%

Tax-free municipal: 9.3%

A-rated corporate: 9.0%

Short-term corporate: 6.6%

Junk corporate: -11.3%

... but Money Flees

Net cash outflows in billions from major bond fund categories, year-to-date through October:

Municipal bonds: -$15.7

Hybrid (stock/bond): -$30.1

Taxable bonds: --$32.6