Bond Fund Investors Beware

While mutual funds made up for some of the ground lost in 2008, taking in $377 billion in 2009, most of that recovery was thanks to bond funds, which accounted for $357 billion of the net inflows.  Morningstar said fixed-income funds took in more flows in 2009 than they saw over the previous five calendar years combined.

Low yields in other income-producing investments, such as money-market accounts and bank CDs, likely pushed some investors into bond funds, and there was a bit of performance-chasing going on, as bonds held up better than most other asset classes in 2008. Most importantly, after experiencing harrowing losses in 2008, many investors reassessed their capacity for risk and increased their portfolios’ allocations to lower-volatility asset classes, according to the report. However, Morningstar warns that bond funds aren’t immune from volatility, and there are risks looming on the horizon that many new shareholders may not fully appreciate.

Sonya Morris, editorial director at Morningstar, noted that taxable bond funds accounted for most fixed-income flows in 2009, but on a historical basis, muni funds had a banner year, gathering an unprecedented $72 billion in assets, and blowing away the previous record of $21 billion in 2006. While demand will likely continue to work in favor of munis in 2010, at the same time, supply will be limited as the Build America Bonds program makes it more attractive for traditional muni issuers to gain financing via the taxable bond market. Those technical factors could support muni bonds in the coming months, according to the report.

On the other hand, state and municipal governments have seen tax revenues decline just as the demands on their resources are increasing. Credit-quality worries are rising to the surface after muni-bond insurance has faded to the background, Morris said. Fund managers told Morningstar they aren’t expecting massive defaults, but downgrade risk is a real concern, and many have ramped up their credit-research efforts as a result.

“If credit-quality issues overshadow the positive technical backdrop, muni-fund shareholders could be in for some volatility over the near- to intermediate-term,” according to Morris.Price and Interest Rate Risk

In addition, the report noted that bond index funds, many of which track the Barclays Capital U.S. Aggregate Bond Index, may face headwinds over the near term because they currently own outsized portions of government-backed bonds. At year-end 2009, Treasuries, agency mortgages, and other government-related bonds made up roughly three quarters of the Barclays Capital U.S. Aggregate Bond Index. Treasuries alone accounted for 28% of the index's assets, compared with just 13% for the typical intermediate-term bond fund. Meanwhile, the index's weighting to corporate bonds amounted to just 18%, half the category average.

Price risk is a concern at the moment, Morris said. Neither Treasury bonds nor agency mortgage-backed securities can be considered attractively priced. The report pointed out that the prices of agency bonds and mortgage-backed securities have been artificially lifted by the Federal Reserve, but the Fed is scheduled to end its buying program in March, which could put pressure on the prices of these securities.

Interest-rate risk is also a worry, as higher-quality bonds (like Treasuries and government-backed mortgages) are more vulnerable to rises in interest rates than lower-rated bonds. Interest rates will eventually rise and when they do, Treasury and agency mortgage bond prices will come under pressure.

At the same time, higher interest rates mean higher yields on money-market accounts and CDs, creating competition for bond funds.

Morris concludes that with risks looming, bond-fund returns could come under pressure, and that could shake out investors who don't have realistic expectations about bond-fund volatility. On the other hand, if fixed-income funds manage to limit volatility relative to other asset classes, they stand a good chance of holding on to their shareholders.

The full report is here.