Bond Funds are Hot — and Risky

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Investors are having a love affair with bond funds, but some fund experts, like stern parents, are urging them to take it slow. What gives?

While fund companies are eager to have new cash come in, they don’t want investors to have bad experiences that could turn them off long-term. Bond funds are riskier than many investors realize, and investors who pile in today could lose money if interest rates rise.

In the week ended Oct. 7, investors poured $15.2 billion into bond funds, while taking $4.4 billion out of stock funds, according to the Investment Company Institute, the mutual fund trade group. Investors have been piling into bond funds all year.

“The latest fund flow data are out, and America just can't get enough of bond funds,” Morningstar Inc. (Stock Quote: MORN), the market-data firm, reported Oct. 9, adding: “In the meantime, U.S. stock funds got no love.”

Although stocks and stock funds have had a great run in recent months, that followed some gut-wrenching losses in 2008 and early this year. Many investors have decided they prefer what they believe to be the greater safety of bond funds.

The trend has been reinforced by bond funds’ strong performance. The average taxable bond fund was up 16.6% this year through Oct. 8, according to Lipper, the market-tracking company. That’s about four times the average return for the past five years.

But on Oct. 9 the Vanguard Group announced a “cooling off period” for its top-performing fund, the Vanguard Capital Value Fund (Stock Quote: VCVLX), which had returned 68.5% this year through September. The fund will not allow investors to open new accounts, though existing shareholders can continue putting in money.

Vanguard CEO Bill McNabb explained the move in a statement: “Despite our efforts, at both a company and an industry level, to educate investors about the perils of performance-chasing, we continue to be concerned about this behavior.”

Performance-chasing means jumping into an investment that has done well. Investors who buy at the peak often suffer losses when their hot holding comes back to earth.

The big gains enjoyed by bond funds this year have been caused by a decline in interest rates, which pushes up the values of bonds the funds own. In a simplified example, investors will pay more for a bond yielding 6% than for one yielding 3%.

But it works the other way, too. If you paid $1,000 for a bond yielding 3%, or $30 a year, no one would give you that much for it if newer $1,000 bonds paid 6%, or $60 a year. In fact, your older bond’s value could fall to $500, so that the bond’s $30 in annual earnings equaled 6% of the price, matching the new market rate. In real life it’s much more complicated than that, but that’s the general idea.

Price changes from interest-rate moves are more severe for long-term bonds than for short-term ones, since the positive or negative effects of rate changes last longer.

Because interest rates are very low right now, there’s more chance they will go up rather than down, making new bond investments risky.

So if safety is your top priority, take a close look at bank savings like certificates of deposit. They’re not especially generous, with the average 12-month CD yielding just more than 1%, according to the BankingMyWay.com survey. But your principal will be safe, no matter what interest rates do.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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