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Ben Baden
Sudden hike in interest rates could really dampen the returns of some bond funds
Timid investors have shown a clear preference for bond funds over stock funds. Through the end of June, investors have poured about
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
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
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.
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
Be selective in the emerging markets. Of the almost
[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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Investing - When Choosing a Bond Fund Keep These Factors in Mind