Investors bailing out of bond funds

Still reeling from last year when bond funds had their worst performance since 1994, more and more financial advisers and investors think the bonds' drawbacks outweigh their advantages.

Personal Finance editor HELEN HUNTLEY E-mail: Click here Archive

By HELEN HUNTLEY

© St. Petersburg Times, published June 25, 2000

Hilda Tripp's municipal bond fund has given her some very good years, but last year wasn't one of them. The share price shrank 11 percent, and even with dividends reinvested, the fund lost 5 percent. This year it is treading water.

Tripp, a Palm Harbor retiree, has been thinking about bailing out.

"My son in Michigan keeps saying, "Stick with it,' but I'm 91 years old. How long can I wait for it to come back?"

Many investors are not waiting. Last year bond fund investors redeemed $5.4-billion more in shares than they bought. This year net redemptions of bond funds were nearly $35-billion through April, according to the Investment Company Institute, an industry group.

The outflow reflects growing disillusionment with bond funds by investors and their financial advisers.

"Money follows performance; it's as simple as that," said Christopher J. Molumphy, chief investment officer for the Franklin fixed income group at Franklin Templeton Funds in San Mateo, Calif.

Not only have bonds faltered, but stocks have soared, widening the performance gap. Although bonds have performed better recently as stocks have become more volatile, bond investors still are smarting from the pain inflicted last year, the worst for bonds since 1994. Even with dividends reinvested, the average government bond fund lost more than 7 percent; long-term Florida municipal bond funds were down nearly 5 percent.

That's particularly unsettling to many fund shareholders because bonds are supposed to be a conservative investment. Bond fund investors typically invest to generate retirement income or provide stability for a mixed portfolio of stocks and bonds. They like the convenience and liquidity bond funds offer but may not expect volatility.

Rising interest rates were the problem in 1999, just as they were in 1994. When rates go up, bonds lose value, as do the shares of the mutual funds that own them.

In 1994 investors pulled a record $64.6-billion more out of bond funds than they put in. The outflow continued in 1995, even though performance reversed.

Now money is leaving again and a lot of it may never come back. Many financial advisers say they have decided the funds' drawbacks outweigh their advantages.

"As a rule, I am not buying these today for my clients," said Douglas Hanke, a Tampa financial planner with Florida Financial Advisors.

The big problem is that a bond fund never matures, leaving investors' principal at risk whenever interest rates rise.

If you own an individual bond and rates go up, your bond is worth less, but if you hold it until maturity, you get your money back. That is not an option with a bond fund.

"There is no maturity, so depending on when you need the money, you may have to sell out at a discount," Hanke said.

You also might be able to sell at a profit if rates fall, but that is not a strong selling point for bond fund investors, who typically are seeking income rather than capital gains.

"You want a bond fund with an extremely steady net asset value," said New Port Richey financial planner Steve Athanassie of Trademark Capital Management. "The concept of a bond fund doesn't make a lot of sense. Right now when investors are pulling out, bond fund managers have to raise capital to meet redemptions so they have to sell bonds at the worst possible levels."

He said he rarely uses bond funds except for a floating rate fund that invests in very short-term securities and restricts redemptions to help maintain stability of principal.

Hanke said his other beefs about bond funds include the management fees and risky strategies some bond fund managers pursue in an effort to increase yields.

But bond funds do have advantages. The most significant are diversification and liquidity. Because a fund owns bonds from so many issuers, a default that might be devastating to an individual bond holder is barely noticeable to fund shareholders.

It also is much easier and cheaper for a small investor to buy and sell bond fund shares than to buy and sell individual bonds.

"We would argue that professional portfolio managers who specialize in bond investing are probably best equipped to make the decisions," said Molumphy at Franklin Templeton. "When we're managing multimillion-dollar bond portfolios, the costs we get are significantly better than what an individual could hope to obtain trading individual bonds."

Some financial advisers who prefer individual bonds say bond funds still have their place. Bond funds commonly are recommended for investing in higher-risk sectors, such as high-yield corporate or foreign bonds.

Sarasota financial planner Marge Schiller said she also recommends them to investors who do not want the added work of regularly reinvesting the proceeds as individual securities mature.

"I also use them if the investment will use systematic withdrawal to fund current spending needs," said Schiller, a planner with Goar, Endriss & Walker.

Cashing in shares makes it easy to spend principal if investors want more income than their investments generate.

Investors who are pulling out of bond funds might be doing it at just the wrong time. After losses in 1994, many funds produced double-digit returns in 1995. Some of those who sell bonds say something like that could be about to happen again.

As evidence, they note that interest rates on many short-term investments are higher than those on long-term bonds, the opposite of the normal relationship. This situation, known as an inverted yield curve, occurs when investors expect lower interest rates in the future.

"When we have an inverted yield curve, which we currently have, that has historically signalled a top or near top in interest rates," Molumphy said.

If rates do reverse, bond fund investors will reap the benefits.

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