If Bond Funds Rally, Investors Won't Miss Out This Time

Investors in bond mutual funds learned an important lesson in 1995, it appears.

That was the year of the biggest bond-market rally since 1986. The average bond fund returned 16% that year, according to Lipper. But so many bond mutual fund investors had cashed out in 1994 -- the bond market's worst year in a generation -- that the bounty of 1995 was shared by relatively few.

This year is the bond market's worst since 1994. The average fund was down 1.1% through the end of November, compared with a 4.8% average loss for all of 1994. That hasn't brought much new money into bond mutual funds -- just $13 billion through October.

But neither has there been a replay of what happened in 1994, when $43 billion fled bond funds.

On the surface, it seems fairly clear that investors have learned that a bad year in the bond market may be followed by a great year, so it pays not to sell at a loss. "Now, there's much greater appreciation of the fact that volatility can occur, so it's not as disconcerting when it does," says Chris Conkey, chief investment officer for fixed income at Evergreen Investment Management.

Adds Mark Fujii, fixed-income product manager at American Century: "By and large, people are moving more to an asset-allocation-type strategy, where they hold things for the long term."

The Market Has Changed Since '94

However, there are important differences between then and now that make it less clear that the mass of investors has learned that lesson, mutual fund-industry executives say. At the very least, they say, the jury is still out.

The first key difference, they point out, is that between 1994 and 1998, a big change occurred in the types of bond mutual funds that attracted the most cash.

Hanging Tougher In the worst bear market since 1994, bond mutual fund investors aren't cashing out the way they did then

Source: Investment Company Institute, Lipper.

As this chart shows, 1991, 1992 and 1993 were fat years for bond mutual funds. But among taxable bond funds, the bulk of the money went into government funds. Nothing wrong with government bonds, except that their excellent credit quality means they pay relatively low interest rates compared to corporate bonds. So when interest rates are rising, as they were in 1994 and this year, a government bond typically suffers much more price deterioration than corporate or high-yield bonds, whose higher interest rates cushion the impact of rising rates.

In the years since 1994, by contrast, most of the inflows into bond mutual funds have gone to corporate, high-yield funds and strategic funds, which diversify across the different types of bonds. In 1993, most of the money in taxable bond mutual funds was in government funds -- $117 billion of a total of $360 billion. In 1998, most was in corporate, high-yield and strategic funds -- $363 billion of $532 billion.

To be sure, those types of bond funds entail loads of risk. Their prices can drop if economic growth slows and nongovernmental issuers seem likely to have trouble making interest payments, or if appetite for illiquid securities dries up (as it did in the fall of 1998).

But in an old-fashioned, bond-market rout -- where interest rates are rising because the economy is growing, inflation expectations are rising and the Fed is hiking the fed funds rate -- those high interest-rate bonds outperform government bonds. Many corporate, high-yield and strategic funds have positive returns for the year to date, even as most long-term government funds are in the red. Thus, it's not surprising that investors have hung onto them.

According to Federated Investors global sales manager Tim Pillion, it also helps that on the whole, bond funds pursue less-aggressive strategies now than they did then (which has helped their performance in this year's bear market).

In the municipal bond market, where the average fund is down 1.9% this year, there have been only small outflows from mutual funds -- $1.6 billion through October. In 1994, by contrast, $16 billion left muni funds. But in another important difference between now and then, 1994 was the year Orange County, Calif., defaulted on its municipal bonds, prompting many investors to flee the sector for fear there would be other defaults.

Stocks Dominate the Picture

Finally, mutual fund executives say, it's possible that many investors are simply too distracted by the vast gains in their stock portfolios to pay attention to what's happening on the bond side.

In 1994, stocks were basically flat, giving investors plenty of time to scrutinize their bond-fund statements. "To me, the asset test will be the first-quarter results," after investors have had a chance to see how their bond funds performed for the year, says Keith Hartstein, senior vice president in national sales at John Hancock Funds.

That investors learned a lesson in 1995 is "certainly the hope," he says. "But past experience has been that memory is far too short."

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