Monday, November 18, 2002
This may be the worst time for investors to buy bond funds, experts say.
MILWAUKEE JOURNAL SENTINEL
Impatient shoppers who switch into the wrong line at the supermarket lose time.
Impatient investors who switch into the wrong mutual fund lose money -- and that's exactly what some professionals say is likely to happen to those who are piling into bond funds.
As of Sept. 30, an estimated $118.8 billion had flowed into bond funds this year -- well above the $87.7 billion bond funds pulled in during all of 2001.
The driver: Many 401(k) plan participants and other investors turned away from stocks.
Bad move, say professional investors, who worry the result of that investment decision will be every bit as ugly as the race into stocks shortly before the bubble burst in March 2000.
"If you were a disciplined investor, three years ago you would have been reducing your exposure to equities and increasing your exposure to bonds -- and now you should be doing the opposite," said Peter S. Lautmann, principal and equity portfolio manager at Kitzginer Lautmann Capital Management Inc.
Longer-term bonds -- and longer-term bond funds in particular -- carry a great deal of risk that could turn into investor losses when interest rates begin to rise.
"Most investors don't recognize that if interest rates go up, that will hurt the performance of their bond portfolio," said Jeff Bryden, managing director of fixed income at Campbell Newman Asset Management Inc. in Mequon, Wis.
Factors involved
A number of factors contributed to the bull market bond investors have enjoyed for the last 20 years. Interest rates peaked in 1981, then began a long slide.
Add declining inflation, shrinking budget deficits and an increase in foreign investors getting into U.S. markets, and you have a formula for strong bond performance.
But now, interest rates are near 40-year lows, and unlikely to go lower. "Under the best conditions, rates will probably remain at current levels going forward," Bryden said.
William A. Priebe's interest rate forecast suggests AA corporate bonds with maturities of seven to 12 years won't provide more yield than their coupon rates -- and could actually turn in overall losses.
"If we're right on our forecast that the 10-year Treasury will move to [a yield of] 4.5 percent by the end of the year, you could lose as much as 10 percent in bond funds, depending on maturity and quality," said Priebe, an equity portfolio manager and president of Geneva Capital Management Ltd. in Milwaukee.
That scenario isn't as gruesome for investors who buy individual bonds. "The bond's price can fluctuate, but if you hold it to maturity, you get your money back," said Robert J. Bukowski, senior consultant at Alpha Investment Consulting Group in Milwaukee.
Bond funds are a different story.
The fallout from rising interest rates can hit bond funds particularly hard.
For example, many financial advisers put their clients into bond funds in 1967, Priebe said. By the 1980s, when interest rates had risen into double digits, some of those bond funds were 30 percent to 40 percent under water, he said.
"The real problem with a bond fund is there's no maturity. It's always been the problem," Priebe said.
Explanation
Here's what happens: As rates rise, bond fund managers want to buy bonds with shorter maturities so they aren't locked into lower yields for a long time.
They start selling the bonds they bought when rates were falling, which have higher yields and longer maturities.
The net asset values of the funds start declining because as their yields rise, the prices of the bonds in the fund go down.
The decline in the price of the fund will often make shareholders sell, which forces the manager to sell more bonds at low prices to raise cash, which causes more shareholders to sell.
Rebalance, Bukowski said.
"If you had a mix of 60 percent stocks and 40 percent bonds, you want to get back to that," he said.
That's pretty much the answer you'll get from almost anyone, from Wall Street public relations departments to industry organizations to investment professionals.
Even if you think one asset class like bonds may underperform, it's nearly impossible to time the market, they say. So be disciplined and stick to your asset allocation.