Investors’ love of bond funds continues in first quarter

It’s been the best of times for bond investors. Could it soon be the worst?

Bond mutual funds, many of which performed spectacularly last year, churned out solid returns in the first three months of this year, with all bond fund categories posting gains.

Individual investors haven’t lost their recent love for the sector. After pumping a net $375 billion into bond funds last year as an alternative to the capricious stock market and low-yielding money market funds, they shoveled $54 billion more into bond portfolios in January and February.

But the specter of rising interest rates -- and the severe damage they can do to bond investments -- is hanging over the fixed-income landscape.

“Seeing the sheer volume of money flooding into bond funds in the past year, it’s hard to think that investors have a good sense of the head winds facing bond funds in coming years,” said Miriam Sjoblom, a fixed-income analyst at fund tracker Morningstar Inc.

With the U.S. economy increasingly showing signs of improvement and the federal government borrowing record sums of money, many market professionals expect the Federal Reserve to begin raising its benchmark rate as soon as later this year.

The fund industry is bracing for possible large-scale redemptions if bond newcomers get spooked by unexpected losses and opt for “taking their money and running,” Sjoblom said.

Many managers, she said, are bulking up on liquid securities that can be sold easily to raise cash without disrupting overall performance.

For much of the last two years, bond funds have been powered by a general decline in market interest rates in response to the economy’s nose dive and the Fed’s easy-money policy to combat the global financial crisis.

When market yields on bonds fall, bond prices rise. But the reverse is also true: Rising yields reduce the value of fixed-income securities.

If history is a guide, the biggest risks from rising rates lie in longer-term bonds, whose value is more sensitive to changing yields.

When rates rose from mid-2005 to early 2006, for example, long-term government bonds incurred sharp losses, with average total return down 5.2%, according to mutual fund firm T. Rowe Price. In 1994, another period in which small investors sought out the perceived safety of bonds, long-term Treasuries skidded 11.1%.

Some investors appear to be aware of the risks of longer-term securities. Of the money that flowed into bond funds in 2009, more than 70% went into intermediate-term and short-term portfolios.

But this time short-term bonds could be at greater risk than longer-term bonds. The reason has to do with the fact that rates on bonds are determined by the marketplace, not by the Fed.

If the central bank raises its benchmark short-term rate by, say, 1 percentage point, yields on many short-term securities -- especially Treasury bills -- are likely to go up by a comparable amount. But yields on longer-term bonds -- and short-term debt issued by corporate and municipal borrowers -- may or may not.

In fact, if bond investors conclude that Fed rate hikes will help head off inflation -- rising consumer prices are also bad for bonds -- that could boost demand for longer-term bonds.

“If the Fed raises rates quicker than expected, long rates actually could come down,” said Steven Huber, manager of T. Rowe Price Strategic Income fund.

Short-term bond funds, meanwhile, face further risk because their yields are so low that they can’t do much to offset a drop in value. “You have a lot less of a yield cushion to protect you from rising rates,” Huber said.

Investors seeking to gauge a bond fund’s interest rate risk can look to its duration, largely dependent on the average time to maturity of the portfolio’s holdings. The higher the duration, the bigger the potential loss from rising rates.

For a fund with a duration of 5, with each 1-percentage-point rise in the portfolio’s average yield, the fund would lose 5% of its market value.

Intermediate-term funds currently have an average duration of 4.5, while long-term Treasury funds are at 12.8, according to Morningstar. In other words, if the average yields of long-term Treasury funds rise 1 percentage point, their value will tumble 12.8%.

But if you have bond funds in your portfolio as part of a long-term asset-allocation strategy, it’s important to know that fluctuations in value caused by interest rate changes tend to even out over time.

For example, bond yields are generally lower now than in 1976. That has boosted bond values. But nearly all of the total return of a diversified bond portfolio since 1976 has come from interest income rather than changes in bond prices, according to Charles Schwab Corp.

One refuge from rising overall interest rates could be high-yield bond funds, even though they soared 47.1% last year and added 4.2% in the first quarter.

That’s because the higher yields of junk bonds can do more to offset a drop in market value. In addition, an improving economy -- a major reason for the Fed to raise rates -- is good for junk bonds because it lowers the risk of borrower default.

In the last two periods of rising rates, junk funds did well, according to T. Rowe Price: They returned 5.7% on average from late 1998 to early 2000, and climbed 4.6% during a similar period in late 2005 and early 2006.

But junk funds are usually more volatile than bond funds overall, and advisors usually don’t recommend them for more than a slice of a diversified portfolio.

One of the big challenges in choosing between bond funds and money market funds is uncertainty over how fast rates will go up.

If the Fed raises rates slowly, investors hiding out in money market funds would forgo the higher yields available in bond funds.

But opting for higher yields could be risky for people who need the money in the next year or two.

“Rates can go somewhat higher and [bond funds would] still outperform money markets because of the yield advantage,” Huber said. “But there is a point at which you’re better off being in money market funds.”