No time like now to avoid bond funds

January 25, 2010
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Even in the most stable of economic times, it’s hard to make much of a case for investing in a bond fund. At this point in time, when bond rates are at an all-time low, there’s little if anything that can be said on behalf of investing in a bond fund.

Yet investors poured their dollars into bond funds at record levels in 2009. In December, more than $31 billion was invested in bond funds (taxable and municipal), with no signs of slowing. In some cases, the investment rate in bond funds was at such a high level that fund managers haven’t been able to put all of the new assets to use. The result has been a cash build-up in bond funds at levels not seen for five years.

All of the above are reasons for those tempted to drop their assets into a bond fund pool in 2010 to resist the inclination.

There are many reasons why bond funds aren’t a good idea under any conditions — and a handful more that hopefully add further conviction to that position in present circumstances.

Foreign news sources reported earlier this month that the world’s biggest investment funds are reducing their exposure to U.S. and British government bonds. Those actions were taken in belief that a rise in government bond yields (interest rates), when coupled with concerns about government finances, could result in higher mortgage and borrowing costs. As those yields rise, bond prices fall, devaluing the funds’ holdings.

That illustrates the core argument for holding back on bond fund investment in 2010. Bond rates have only one place to go from here, and that is up. For bond fund investors, upward movement means one thing for their investments — their value is headed downward. Add to that situation the likelihood in the next couple years of some inflation, and the prognosis for bond funds sinks further.

For investors, there also is the inherent challenge posed by bond fund investments of acquiring embedded gains and tax consequences: all pain and no gain.

And bond fund investors face the risk of getting hit harder than individual bond holders when bond prices fluctuate. Bond fund values change every day, and if rates rise, the fund’s share price falls. While that fall won’t be as precipitous as those on the equities’ side, a bond bear market can last longer than an equities bear market.

Let’s take a quick look at bond fund results in 2009:

  • Only one category of taxable bond funds posted a loss: U.S. Treasury bonds (6.48 percent on average).

  • A-rated corporate bonds posted an average gain of 15.7 percent.

  • Single-state municipal funds averaged a similar gain.

  • The yield curve steepened, hitting 271 basis points for the gap between two-year and 10-year Treasuries. The average gap has been approximately 100 basis points for the last 20 years.

What’s the investor to do?

Regardless of conditions, opportunities exist in the investment in individual bonds as a way to generate income and reduce risk. The purchase of individual bonds also provides investors with a chance to control their portfolio in a way that bond funds don’t. Bond fund investors don’t know what the individual issues are in the portfolio. That lack of transparency can open the door to management style drift and credit issues without investors realizing the change has begun.

An argument can be made that bond funds provide more protection from volatility, but the counter to that argument is that investments in individual bonds allow investors to control their portfolios and determine whether they meet benchmarks.

With an economic forecast of slow near- and long-term growth, there appears to be little threat to the individual bond market until that time inflation begins to appear. If we were facing a rapid economic recovery, the out-performance of stocks would offset any interest in bonds — but that isn’t likely to be the case.

Investors continue to be well-served in looking for highest quality bonds, which is underpinned with a strategy that looks at individual income needs, time horizons and tax situations. With the possibility of the bursting of a bond-fund bubble lingering, individual bonds afford control, earnings and risk reduction for investors.

Julie M. Ridenour is director of business development with Norris, Perné & French LLP.

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