That Sucking Sound Is Money Leaving Bond Funds

It's been a cold winter for bond mutual funds.

In December, TheStreet.com wrote that bond mutual funds were hanging on to their assets even though the bond market was having its worst year since 1994. While the story acknowledged that the year wasn't yet over and the outflows might still come, its main premise couldn't have proven more wrong.

It takes a while to find out about mutual fund cash flows, since the figures are released with a month-long lag. But here's what's known so far: December and January were the bond mutual fund industry's two worst months ever. And February doesn't look like it was much better.

Whether the industry is at a critical point isn't clear. Will fund companies be forced to merge bond funds and fire managers on a large scale if the outflows continue? For obvious reasons, most of the titans don't want to discuss the situation. Those that do would rather point out that bond mutual funds have had to fight the surging equity market for a piece of the pie for years now, and that all eras eventually come to an end.

How bad has it been for bond mutual funds lately? From January to October 1999, bond mutual funds attracted $13 billion, according to the Investment Company Institute. Taxable funds gained $14.4 billion in that period, while municipal funds lost $1.6 billion.

By comparison, in the bond bull market of 1998, taxable funds added $59.4 billion while muni funds added $15 billion.

But the last two months of 1999 -- December in particular -- turned the year into the industry's worst since 1995. Taxable funds wound up having added just $6.7 billion, while muni funds bled $12.1 billion.

It's not unusual for money to flee aching asset classes in December, when investors take stock of their portfolios and look for losses to book against their gains. Especially in a year when the gains have been outsized, as they were in stocks last year.

What is unusual is for the hemorrhaging to continue into January. According to figures released by the ICI last week, taxable bond funds saw outflows of $8.6 billion in January, while muni funds lost $4.0 billion.

For taxable funds, it was the worst month ever. For muni funds, it was the second-worst after December, a month in which outflows totaled $7.2 billion.

For both categories of funds, the losses exceeded any previous losses by a wide margin. On the taxable side, the most that had ever been lost before December, when $6.3 billion flowed out, was $2.1 billion, in March 1997. On the municipal side, the biggest monthly loss before 1999 was a $1 billion outflow in August 1996. Total assets of bond funds have grown over the years, but not by enough to make sense out of what happened.

Bye-Bye, Assets More money fled bond mutual funds in January alone than in any full year since 1994.

Source: Investment Company Institute

And it looks like February didn't stem the tide. According to AMG Data Services, during the four weeks of February, $4 billion fled taxable funds, and another $1.4 billion left muni funds.

But while the losses have been massive, industry executives say they don't see a shakeout in the near future.

"This is something we'd been dealing with already, so I don't think it means imminent layoffs," says Randall Merk, chief investment officer for fixed income at American Century, the eighth-largest bond fund company, with $18.4 billion under management. "But if other fund families are like ours, they're continuing to look at [whether they] need as many fixed-income vehicles."

It wouldn't be surprising, Merk said, to see fund companies start folding intermediate-term funds into either short-term funds or long-term funds, for example. "As an industry we may have overengineered our product lines to be too granular."

But that's a process that has been under way to some extent since 1994, when there were 1,012 municipal bond funds and 442 taxable government bond funds, according to the ICI. By last year, those numbers had declined to 888 and 379.

Mainly, though, bond fund industry executives remain convinced that eventually, the tide will turn.

"Equity funds are taking all the money; it's that simple," says Bill Dawson, head of fixed-income at Federated Investors, the 10th-largest bond fund family. "The economy's booming, there were no Y2K problems and stocks are hitting more highs. How much encouragement do you need?"

But all this has created "a disconnect with historical fundamentals -- which is why the Fed's in action," Dawson says. Either the Fed will slow the economy by hiking interest rates or the bond market will, he says. At which point ownership of bond mutual funds should regain some of its appeal.