These are the best times bond mutual funds have seen since the dawn of the Internet era. In the past year, the more than 3,800 bond funds tracked by Bloomberg have returned an average 9.5 percent, leaving the average stock fund, with its average 5 percent loss, in the dust. To give the story some extra spice in early 2001, funds operating in the risky world of junk bonds have rallied after getting trashed last year.
Bloomberg's high-yield bond fund average is up 3.5 percent in the first three weeks of January. Who knows, bond funds as a group might be poised to halt the drastic decline in their share of the mutual fund market that dates back to 1993. At the end of that year, bond funds accounted for 30 percent of all the assets in mutual funds. Since then, according to the latest data from the Investment Company Institute, their piece of the pie has shrunk to 12 percent. A big reason for that decline has been the boom in stock funds inspired by the growth of the Internet and other high-tech marvels, which last year finally tailed off.
"While the 90s were the decade of wealth accumulation, this decade looks more like a time for wealth preservation," says Theresa Hamacher, chief investment officer at Pioneer Investment Management Inc. in Boston, which manages $20 billion in funds and other accounts. "Stocks will probably outperform other assets, but by more modest margins. Investors concerned about risk will revert to bonds."
There are some big clouds left in this brightening picture. Yes, the Federal Reserve cut short-term interest rates in early January and is expected to follow up with more reductions as 2001 unfolds.
But forecasting the bond market is never simple. Long-term interest rates could turn upward in a heartbeat, depressing bond prices, if investors start to suspect that the economy isn't slowing as much as was thought when the year began. Or they might sour on bonds if Congress passes a big tax cut, as President Bush has proposed.
The economic stimulus of a tax cut could stir up inflation worries. In bond traders' calculations, it also stands to increase the prospective supply of Treasury securities, tipping the scales toward lower bond prices and higher interest rates. However events unfold, bond funds have more repair work to do on their image among investors. At their peak in 1993, they had more assets than money market funds investing in short-term interest-bearing securities. Today money funds are more than twice as big as bond funds.
If the Fed keeps cutting short-term interest rates, money fund yields will inevitably decline from the recent highs of about 6 percent. They have already started down, to an average of 5.7 percent as of Jan. 16, according to IMoneyNet Inc. That is no guarantee, though, that investors will cool on money funds. In the last two cycles when the Fed cut rates, 1995 to early 1996 and in 1998, money funds kept attracting far more new money than bond funds anyway.
Though bonds usually bring better returns over time than money-market investments, many investors have developed a distaste for bond funds because they fluctuate in value and give their owners no set time to expect their money back, as individual bonds do at their maturity date.
Back in the days when bond funds were popular, "people bought not really understanding what risk they were taking," says Don Phillips, managing director at the research firm Morningstar Inc. in Chicago. "The industry overpromised and underdelivered." Perhaps now investors, wiser in the ways of the markets, are ready to let those bygones be bygones. Bonds, after all, are a time-honored asset class with a legitimate claim to a place in fund buyers' investment plans.
"Has the time come for bonds? It's always time for bonds because it's always time to be diversified," says Victoria Martinsen, editor of the Safeco Update newsletter published by Safeco Asset Management Co. in Seattle. But it's a long road back to a 30 percent share of the business. Right now many bond fund partisans would settle for a few steps in that direction.
Chet Currier is a columnist for Bloomberg News.
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