When Choosing a Bond Fund Keep These Factors in Mind
Ben Baden

Sudden hike in interest rates could really dampen the returns of some bond funds

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.

[See Is Your Portfolio Ready for A Double-Dip Recession?]

Abandoning money market funds. Sjoblom's one concern is that many investors have deserted money market funds because they're yielding almost nothing in today's low interest rate environment. Through the end of June, money market funds have seen net outflows of more than $487 billion since the beginning of the year, according to Morningstar. While those money market funds may be yielding close to nothing, it may not be wise for investors to move money that they can't afford to lose into riskier asset classes. "There have been tons of flows into short-term bonds funds and short-term muni funds, and I wonder if people really understand those funds can lose money if interest rates were to rise suddenly," she says.

Be selective in the emerging markets. Of the almost $140 billion that has poured into bond funds, about $7 billion worth of investors' money has made its way into emerging markets bond funds. Why the sudden inflows? One word: debt. Many developed nations like the U.S., UK, and some in Europe have massive deficits, while other emerging markets countries like China boast fiscal surpluses, fast-growing economies, and hungry consumers. "Their debt loads are significantly lower than their developed markets counterparts," says Luz Padilla, portfolio manager of the DoubleLine Emerging Markets Fixed Income fund. Over the past year, the category has put up big numbers--returning about 20 percent. Padilla is optimistic about the potential for the asset class to do well, but she cautions investors that some of these short-term returns aren't sustainable over the long run. Going forward, she believes investors should expect these funds to return somewhere in the neighborhood of 8 percent rather than 10-plus percent.

[See Why Emerging Markets Belong in Your Portfolio.]

If you're interested in diversifying your portfolio through investments in emerging markets debt, Padilla has one warning: Be aware of country-specific risks. Emerging market countries present a lot of opportunities, but there are risks that go along with investing in countries whose businesses use less transparent accounting techniques and whose governments are often times unstable. While there are many funds out there that broadly track emerging market indices like the JPMorgan Emerging Markets Bond Index, Padilla believes investors need to be more selective. She points to countries like the Philippines and Venezuela, which both make up fairly large parts of the index. The Philippines, she believes, is overvalued. As for Venezuela, Padilla says she has stayed away from there for a long time because she believes there is a chance that one day Hugo Chavez could wake up and decide he didn't want to pay off his country's debt anymore. "What I've become wary of is when I start hearing people saying, 'Oh I have to be invested in certain countries because I can't be underweight a certain country or a certain region like Asia,'" she says. "To me that tells me that people aren't necessarily doing their homework."

Padilla also says investors need to dig down into exactly what kind of debt their fund is holding. She says many funds are heavy in sovereign debt right now (it makes up a large part of that index), but she says her team is focusing on shorter date high-quality corporate bonds for the time being because they present more attractive yields and the repayment risk is low.

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