Investors Flock to Bond Funds, But What Happens When Rates Rise?

The amount of money flowing into bond mutual funds hit a dizzying pace this year. If the trend continues, bond funds will attract more than twice as much new money as they did in 2008 and a stunning 11 times more than investors are putting into stock funds this year.¹

Although bond funds don’t ordinarily enjoy greater inflows than stock funds, this sometimes occurs during periods of stock price volatility. This development is not surprising, but it is alarming nonetheless. Here’s why.

Interest rates are low and the Federal Reserve is likely to keep them low for the foreseeable future. As long as joblessness remains a problem, the Federal Reserve will be reluctant to raise interest rate targets and, in fact, may have little reason to do so. It has been the Fed’s habit to raise rates when the economy is growing too fast and is at risk of high inflation. But an economy with high unemployment is not likely to suffer from too-rapid growth. Plus, job creation would probably suffer from higher interest rates.

But interest rates will inevitably go up, and when interest rates rise, the value of existing bonds typically falls, which can adversely affect a bond fund’s performance. Of course, the pain will not be evenly spread because bond funds will react differently depending on their objectives, but the effect on the bond market could be pronounced.

Many investors may have piled into bond funds thinking they were a “safe” alternative to stock funds. The S&P 500 lost 37% of its value in 2008, and investment-grade corporate bonds gained 7%.² Investors who were smarting from their losses may have soured on stocks and decided the conservative return potential in the debt markets might be more appealing than the chance of suffering further losses in the equity markets. In the financial world, these investors are “chasing performance,” but they could be setting themselves up for yet another round of losses.

Bonds vs. Bond Funds

It’s important to note the distinction between bonds and bond funds. An investor who buys individual bonds is typically interested in generating income and preserving principal. This is considered a fairly conservative strategy, and it could help insulate bond investors from fluctuations in interest rates until their bonds mature. Investors who are careful to stagger the maturity dates in their bond portfolios may be able to further reduce the risk of having to reinvest a large percentage of their principal when rates are low.

Bond funds, on the other hand, may employ a less conservative strategy by trading bonds before they mature in order to pursue gains by taking advantage of fluctuating interest rates. This may allow them to offer greater return potential, but usually with higher risk. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with the underlying bonds in the funds.

Bond funds can play an important role in an investment portfolio, but they shouldn’t be thought of as a safe harbor to park money until the stock market settles down. Any decision to purchase a bond fund should be made based on your personal circumstances, such as your time horizon, risk tolerance, and personal goals.

Mutual funds are sold only by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

1) Investment Company Institute, 2009
2) Thomson Reuters, 2009, S&P 500 Composite Index (total return) and the Citigroup Broad Investment-Grade bond index for the period 12/31/2007 to 12/31/2008. The performance of an unmanaged index is not indicative of the performance of any particular investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results.

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2009 Emerald.