Will Bond Funds Come Back to Bite Investors?

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A couple meets with their financial advisor.

Investors, spooked by the roller coaster ride in the equity markets, the "flash crash," and sovereign debt problems overseas, are flocking to bond funds for safety and yield. But industry experts say that investors who wrongly think this niche will weather them safely through the economy's ups and downs may be in for a rude — and costly — awakening.

"I have been saying since January that the bond fund area is a big bubble, but that bubble continues to expand and expand and expand," says Marilyn Cohen, author of "Bonds Now!" and president of Envision Capital Management. "I'm extremely worried because when it does pop, I think it's going to have an ugly ending."

Investors burned in the volatile equity markets have been marching into bond funds en masse over much of the past 18 months. In 2009, about $8 billion flowed out of equity mutual funds while a staggering $365 billion moved into bond funds, according to Madeline Schnapp, director of macroeconomic research at TrimTabs Investment Research. So far in 2010, about $6.5 billion has flowed into stock funds while $155.7 billion has moved into bond funds.

At the same time, many investors, frustrated with the low yields offered on money market accounts and CDs, are moving cash into bond funds. "The miniscule payouts on those [short-term] investments have likely pushed income-hungry investors out the yield curve into bond funds," says Sonya Morris, editorial director of Morningstar's Mutual Funds.

But Cohen frets that many of these wide-eyed investors just don't get it. "I think a lot of the money that's gone into bond funds is first-time money — people that were in CDs and money market funds for decades because that's what they understood and that's where they could have safety and security," she says. "If I'm right and a lot of the money that's flooded into bond funds is uneducated and unsophisticated bond money; it's going to be ugly."

What many recent bond-fund investors may not know is that these funds can be buffeted by rising inflation, credit downgrades, and the daily diet of frightening headlines about sovereign default risk, as each of these things can affect the underlying value of bonds held by the fund. As an example, when inflation skyrocketed and interest rates spiked up in the recession of the late 70s and early 80s, many bond investors lost 40% to 50% of the value of their principal. More recently, when the credit market collapsed in 2008, some bond funds were down 30% or 40%. Although most of these funds bounced back in 2009, it's a wild ride that bond fund investors aren't accustomed to.

There's another risk factor that may not make the financial headlines. Supply and demand for bonds can significantly influence prices. The Federal Reserve bought up a trillion dollars of mortgage bonds over the to help support the financial industry; at some point it will look to unload those bonds, which could send interest rates higher. Also, global demand for U.S. Treasury bonds has been high in the wake of the Greek sovereign debt crisis and concerns about the euro, as many considered Treasuries a safe haven. All of this demand has kept yields down. But once foreign investors move out of Treasuries or the auctions don't go well, demand will dry up and yields will rise, which would be "extremely worrisome" for bond holders, says Cohen. The result could be massive redemptions from bond funds, which would exacerbate the selloff in bonds. "The redemption risk is gi-normous — huge!," says Cohen.