Rich Returns Await Depressed Bond Funds

With credit markets frozen, most bond mutual funds have been clobbered.

During the month ending Oct. 9, the average high-yield bond fund dropped 15.5%, while Inflation-protected funds declined 7.2%, according to Morningstar. Even low-risk intermediate municipals fell 5.6%.

Seeing the carnage, some investors have dumped their fund shares, concluding that it pays to own individual bonds instead of bond mutual funds. When you hold a high-quality bond, you are likely to receive the principal back on the maturity date, they think. In contrast, mutual funds provide less certainty. When rates rise, fund share prices tend to fall. Because the prices fluctuate, you can never be sure what the value of your holding will be on any day.

But for most investors, bond funds remain the best choice. Individual bonds have posed special risks in the downturn. For starters, it has become very difficult for retail investors to trade bonds in recent weeks. With markets frozen, there have been few new issues of municipals or corporate securities. Investors seeking to sell their bonds have found few takers. To unload small municipals, investors have been forced to take haircuts, selling bonds at big discounts.

Meanwhile, bond mutual funds have continued to trade smoothly. Investors seeking to buy have gained immediate exposure to bonds at low prices. Panicked shareholders who wanted to sell have faced few problems in making redemptions and obtaining cash.

In addition to providing easy access to fixed-income securities, mutual funds can deliver higher returns for retail investors. To appreciate why, consider how investors fare in the kind of falling markets that we have experienced lately. With investors dumping bonds in the past year, prices have fallen, and yields on many issues have climbed. For example, yields on 10-year investment-grade municipals have risen from 4.0% to 4.2%.