With the first half of 2010 in the books, timid investors have shown a clear preference for bond funds over stock funds. Through the end of June, investors have poured about $139 billion into bond funds and just under $3 billion into stock funds, according to Morningstar. Year-to-date, long-term government bond funds are by far the best-performing asset class—returning more than 13 percent.
Investors have flocked to bond funds for a number of reasons, including concerns over a wobbly stock market and fears that the U.S. might fall into a double-dip recession. The flash crash in May (when the Dow Jones Industrial average fell by roughly 1000 points in intraday trading) didn't exactly inspire confidence in stock market investors either. "There could be some really legitimate reasons for people pouring into bond funds," says Miriam Sjoblom, Morningstar's associate director of bond analysis. "It could be that in 2008 investors could discovered they owned too much of their portfolio in stocks for their risk tolerance."
On the other hand, investors may not know what they're getting themselves into entirely. "The returns and the opportunities that were available in 2009 were once-in-a-decade-type investment opportunities, so if you're looking at the fixed-income market with those kind of expectations I would say you're probably going to be disappointed in your returns," says John Diehl, senior vice president in the retirement division at the Hartford.
It's important to make sure you're making a well-informed decision. Whether there is a bond bubble brewing or not, here are four themes to consider when selecting a bond fund in today's tumultuous investing climate:
Flight to safety. Diehl says his biggest worry is that the majority of the inflows into bond funds are driven by fear and panic. "If fear is the primary driver for why people are buying bond funds, then in my mind the biggest risk is an overconcentration in the most secure securities like treasuries," he says. Regardless of what asset class investors are entering or exiting, they need to be aware of the importance of diversification. Treasuries are backed by the full faith and credit of the U.S. government, so they're virtually the safest investment that money can buy. When there is a lot of uncertainty in the markets, investors generally rush into treasuries. Diehl is concerned that with treasury yields near all-time lows, investors aren't being compensated enough for their investment.
Risk of interest rate hikes. There hasn't been a clear indication of when rates will raise, but when you're close to zero all you can do is go up, Diehl says. The Federal Reserve has kept the target range for the federal funds rate—what the Fed charges banks to borrow money on a short-term basis—between zero and 0.25 percent since December 2008 and repeated its pledge to keep rates low for an "extended period" since March 2009. "We're in a 30-year decline in interest rates," Diehl says. "If you think about 30 years of interest rate decline, it's probably very easy for people to forget what happens in a rising [rate] environment." Investors who are parked in ultrasafe investments like treasuries could see their returns slashed once the Fed finally raises rates.
No one can predict exactly when rates will rise, but you can protect yourself by diversifying your bond investments by duration (a measure of interest-rate sensitivity), credit quality, and sector. Diehl suggests more investors consider investing in corporate bonds or even to a certain degree in high-yield bonds (which are generally more risky than other types of fixed-income asset classes). The Hartford currently believes that high-yield default rates in 2010 will be around 5 percent, while the default rate in investment-grade—or the highest quality—corporates will be below 1 percent. "So they look at that and say default losses should remain contained, therefore if you're getting the yield advantage in those types of securities it may be good to diversify into that," Diehl says. If investors get caught allocating too much of their portfolio in low-yielding, safer investments like treasuries then they could see major hiccups in their returns—or even losses—as interest rates are raised over time.