Bond-Fund Buyer Beware

By Daniel Kadlec

Investors are courting an old flame: bond mutual funds. But how sincere are their intentions? The relationship sputtered in 1994, when bond funds logged their worst year in six decades and investors fled the church in a panic. Now they're back for another fling. In January net new cash flowing into bond funds surged to an estimated $11.5 billion--the most since August 1993. The disturbing thing is that people probably don't understand this fickle mate any better today than they did in 1994.

The underappreciated irony of bond funds is that while they invest in bonds they don't behave like them. Bond funds cannot guarantee return of principal because, unlike individual bonds (and perhaps your ex), they never mature; bond-fund returns, unlike bonds held until maturity, are tied as much to daily price movement as to the interest rate they pay. And the income generated, rather than being fixed, vacillates with market rates. These differences are so fundamental that it's a stretch even to call them bond funds. They're more like a stock. In fact, if you have money in a bond fund, what you really own is common stock in a company that invests in bonds. That stock goes up and down along with the value of the company's assets, which in this case are mostly bonds but sometimes include exotic derivative securities. Clearly, investors seeking to preserve capital and earn a fixed-income stream for a set period of time have no business flirting with such a beast. They should go for individual bonds. Yet bond funds are routinely marketed and accepted as apt substitutes.

Bond funds do have some good features. They are easy to buy and sell. The minimum investment is in the thousands--not the tens of thousands, as with many individual bonds. And in a stable interest-rate environment, bond funds really are a suitable bond substitute. Just make sure you know what you're getting. There are plenty of low-risk, short-maturity funds. It's the funds that buy 10-, 20- and 30-year bonds that test your emotions. Both types, incidentally, are staples in 401(k) plans. Many people had no idea what they had got into back in '94, when rates soared and, according to Lipper Analytical Services, the average general Treasury-bond fund fell 6%. "Bond-fund risk is just not well understood," notes John Rea, an economist with the industry trade group Investment Company Institute.

So why are bond funds suddenly so popular? The Asian economic crisis chased some investors to perceived safe havens like Treasury bonds. But mainly it's a play on interest rates, which could reach dramatic new lows if inflation continues to subside. When rates fall, bond funds excel. That was the case in '95, when T-bond funds returned an average 22%. But there's an insidious side to bond funds even when rates are falling: the income streams they provide decline because fund managers must buy new bonds that pay ever lower interest. The $1 billion PIMCO High Yield Fund paid 10[cents] a share in interest income as recently as September. Today it's only 8[cents] a share--a 20% haircut. The decline is largely the result of $200 billion of new money invested at lower interest rates.

Income erosion is a problem serious enough so that bond funds should probably decline new money in periods when rates are moving down sharply, like now. That won't happen, though. Now that bond funds are turning heads again, their managers want to enjoy it. If only the oglers knew what they were looking at.

Daniel Kadlec is TIME's Wall Street columnist. Reach him at [email protected]