High Yields Lure Investors Back to Bond Funds

After a long dry spell, money is once again flowing into bond funds. But recent investors are not necessarily the safety-seekers these funds have traditionally attracted. In fact, it's quite the opposite. Most new cash appears to be going into risky junk-bond funds.

Investors seem to be chasing the double-digit yields many of these funds are sporting, a situation that leaves some financial planners uncomfortable.

"It's entirely clear to me that people are stretching for higher yields and taking on more risk than they need to," says Frank Armstrong, president of Miami-based Managed Account Services and chief investment strategist for DirectAdvice.com.

During the first week of June, investors plowed an estimated $850 million into high-yield, or junk bond, funds, while all other categories of bond funds were collectively in the red, according to liquidity-tracker TrimTabs.com.

It's the first good news bond fund managers have gotten in quite a while. Cash flows to stock funds had been outstripping flows into bond funds for years. But the gap was particularly wide last year as stocks soared and bonds stagnated. In 1999, stock funds took in $188 billion in new cash, while bond funds lost more than $5.5 billion, according to the Investment Company Institute, the fund industry's trade group.

Stock Fund Assets Outstrip Bond Fund Assets

Source: Investment Company Institute. *Through April 30.

Junk-bond yields seem to be about the only thing stock-focused investors find attractive about bond funds these days.

"The average high-yield bond is paying a 12% to 13% distribution right now, and that's finally big enough to steal money from equities. I've never seen consistent flows into bond funds without competitive yields," says Barry Evans, chief fixed-income officer at Boston-based John Hancock Funds.

Evans prefers investment-grade corporate bonds right now, and says high-tax-bracket investors can find 9% after-tax yields in the municipal bond market. But he concedes that investors will probably focus on higher-yielding bonds first.

Problem is, there's no such thing as a free lunch: Those higher yields come with significant risk. High yield is a nice way of saying below investment grade. These bonds are typically issued by companies that get low credit ratings from agencies like Moody's Investors Service or Standard & Poor's. Issuers have to pay a higher yield to compensate investors for the risk they're taking that the company could default on its obligation to pay bondholders their interest and principal.

Consider that the high-yield bond fund category's worst calendar-year return in the 1990s -- a 9.6% loss in 1990 -- is nearly double the worst return for any other bond fund category, according to Morningstar.

Most asset allocation models prescribe at least a modest portion of bonds for most investors, but it doesn't look like many investors have been taking that advice over the past few years. Since 1995, the number of stock funds and stock-fund accounts have more than doubled, while the same figures for bond funds have essentially flatlined, according to the ICI.

Stock Fund Far Outnumber Bond Funds

Source: Investment Company Institute. *Through April 30.

The reason: performance. Over the past five years the average diversified stock fund has posted a 20% annualized return, compared to just 5.4% annually for the average bond fund, according to Lipper.

That's not unusual because bonds have historically underperformed stocks and are typically used in combination with stocks to reduce volatility and provide current income. Planners fear many investors may be using high-yield bond funds to cushion their portfolio against risk without realizing they're using the wrong tool.

"People are chasing performance, and that's a problem. They're probably ignoring plain-vanilla bonds that do that very important job," says Ron Roge, a financial adviser based in Bohemia, N.Y. "It has been very hard to put people in bonds over the past couple of years."

Roge typically uses investment-grade bonds and convertible bond funds (consisting of bonds that can be converted at maturity into equity shares of the issuing company) for the fixed-income portion of his clients' portfolios. Most planners say investors can own high-yield bonds as part of the bond portion of their portfolio, but that they should also include investment-grade corporate bonds and U.S. government bonds, too.

One way to build a diversified bond position is to blend U.S. corporate, U.S. government and foreign-bond funds. A shortcut is to shop for a solid, lower-risk strategic income fund where a pro opportunistically spreads your assets among each of these sectors. (See a recent Saturday Screen for a selection of low-cost strategic income funds with solid track records.)

Only time will tell if many investors will broaden their bond interest. Planners aren't too confident, given how tough it has been to get investors to look at bond funds. Hancock's Evans knows he won't ever be as popular as tech-fund managers were when they were racking up triple-digit returns last year.

"We're always the unloved cousin of stock-fund managers. When we have a mid-double-digit return we're happy, but that's what equities have regularly gotten over the past few years. I just can't be king of the cocktail party," he says.