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Will New Bond Fund Aficionados Stick Around?

Although bonds witnessed the most inflows of any asset class last year, investors must be wary of the possible risks on the horizon.

Sonya Morris, 03/08/2010

Investors flooded bond funds with cash in 2009. For the year, U.S. open-end bond funds took in $357 billion, far more than any other asset class. For perspective, fixed-income funds took in more flows in 2009 than they saw over the previous five calendar years combined.

Several factors explain this stampede. Low yields in other income-producing investments, such as money market accounts and bank CDs, likely pushed some income-hungry investors into bond funds. There was probably a bit of performance-chasing going on, too. Bonds held up better than most other asset classes in 2008, and they also outperformed equities for the decade, as measured by the major market indexes.

Finally, and perhaps most importantly, after experiencing harrowing losses in 2008, many investors may have reassessed their capacity for risk and increased their portfolios' allocations to lower-volatility asset classes.

True, bond funds can serve to smooth out total portfolio returns; however, they aren't immune to volatility. In fact, there are risks looming on the horizon that many new shareholders may not fully appreciate. If these risks reveal themselves, it could test the patience and loyalty of these newfound bond investors, particularly if their expectations are unreasonable. Here are a few areas to watch in 2010.

Credit Worries Hang Over Muni-Bond Funds
Taxable bond funds accounted for most fixed-income flows in 2009, but on a historical basis, muni funds had a banner year, gathering an unprecedented $72 billion in assets. That blew away the previous record of $21 billion in 2006.

The factors that have fueled flows into taxable bond funds--low yields and investors' risk-averse mood--also buoyed muni-fund flows in 2009. In addition, many have increasingly turned to tax-conscious funds in anticipation of higher tax rates in 2011, when the tax cuts enacted during the Bush administration are set to expire.

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