After big ride, bonds may have weak legs


The party in bond mutual funds stayed in full swing in the third quarter, but you might want to start bracing for the morning after.

Most categories of bond funds racked up another round of strong returns in the three months that ended Sept. 30. After investors continued to regain their footing from last year’s credit market meltdown, some of the higher-risk areas, such as high-yield corporate and municipal bonds, now boast year-to-date returns topping 30%.

“There has been a complete sea change from the fourth quarter of 2008,” said Robert Auwaerter, head of the fixed-income group at mutual fund giant Vanguard. “As people realized that Armageddon was not coming, they’ve been willing to take on more risk.”


That increased appetite for risk, coupled with near-zero yields on money market funds and skepticism about how long the stock market’s recent boom will last, has opened the taps on a virtual Niagara of cash flowing into bond mutual funds.

Investors pumped a net $270.5 billion into bond funds in the first nine months of the year, TrimTabs Investment Research estimates. That intake accelerated in recent months as $12 billion was pulled out of U.S. stock funds in August and September.

“There’s still a lot of reluctance, especially on the part of retail investors, to put money back into equities, and that’s helping to keep money flowing into bonds,” said Jeff Tjornehoj, senior research analyst at mutual fund tracker Lipper.

Even ultra-safe U.S. Treasuries gained ground in the latest period, despite the widespread return to more-risky assets. Long-term government bond funds averaged a total return of 5.7%. That was much better than the group’s losses of 6.7% and 8.3% in the first and second quarters, respectively, when investors were bailing on Treasuries in earnest, reversing last fall’s frantic flight to safety.

In the municipal bond sector -- which enjoyed a robust third quarter with returns on long-term muni funds averaging 9% compared with 3.9% in the second quarter -- almost $60 billion of new money poured in during the first three quarters, according to fund manager Neuberger Berman. That’s almost double the full-year inflow that muni funds enjoyed during the peak year of 1993, the firm said. Is this yet another case of bedazzled investors throwing money into a mutual fund category after the easy money has already been made?

Some analysts and fund managers believe that could be the case. For instance, the stellar returns notched by high-yield funds, which led all fixed-income categories with quarterly returns of 14.3% for high-yield muni funds and 12.9% for corporate junk funds, were the result of a snapping back from the gruesome losses the funds suffered last year, says Lawrence Jones, a bond fund analyst at Morningstar.


“People have to ask how much more reward are you going to get between now and the end of the year,” Jones said. “Is it time to start reallocating money into less-risky areas of fixed income, like certain areas of the Treasury market?”

Even investment managers are reluctant to promise a repeat of the quarter’s juicy returns.

“The high-yield market’s third-quarter performance was off the charts and investors should not expect gains to continue at the same pace,” said Martin Fridson, head of money management firm Fridson Investment Advisors.

Many of the same warnings were heard at the end of the second quarter, but Fridson and other managers aren’t ready to declare a “bond bubble” just yet. Barring a retreat by the U.S. economy into a double-dip recession, Fridson said, high-yield bond funds should continue to show positive, if less spectacular, returns in the months ahead.

Indeed, the current unsteady state of the U.S. economy, especially the stubbornly high unemployment rate, is likely to rein in inflation hawks at the Federal Reserve and keep interest rates at current levels at least through mid-2010, said Delmar King, co-manager of the MMA Praxis Intermediate Income fund.

“We don’t think there’s much of a chance that the Fed will tighten until mid-year at the earliest, and even then it’s likely to be slow,” King said.

That said, there are signs that the rally in municipal bonds, at least, may be faltering. A lack of supply helped push muni prices higher -- and yields lower -- in the third quarter as investors seeking tax-exempt returns competed for a shrinking pool of bonds.


One reason for the short supply is that many state and local governments have been issuing federally subsidized Build America Bonds, which are a cheaper way for local governments to borrow but are unattractive to investors demanding tax-free income. When the Los Angeles Unified School District issued $2 billion of bonds recently, more than two-thirds of the issue was taxable Build America Bonds.

But with the low supply of munis pushing their yields to the lowest levels in decades, buyers have begun to balk, pushing yields up a bit. California last week had to cut the size of a planned $4.5-billion sale of general-obligation bonds. If yields keep rising, that would pull down prices of existing bonds and crimp fund returns -- much to the disappointment of those who have been throwing cash at the sector.

“I’m not prepared to say it’s a bubble at this point, but it’s something that bears watching,” said James L. Iselin, a senior portfolio manager for Neuberger Berman’s municipal bond team. “I think it would be unrealistic for investors to expect that strong of a rate of return going forward.”