Investors hunting better returns increasingly turn to bonds

KANSAS CITY — Americans have decided its moving day for the old nest egg.

We're frustrated with a stock market that spent the summer erasing gains it made early this year, taking us exactly nowhere in a decade. We're fed up with savings that can’t earn a dime.

We're searching for relief from stock prices' unnerving volatility, the economy's dimmed prospects for recovery and high unemployment's stubbornness.

So we're changing our wagers in hopes of finding some peace and making some money.

We’ve pulled billions out of U.S. stocks to invest them overseas. We’ve drained even more out of those no-pay money funds.

And we’ve found a new darling on the block — bonds. We’re learning to love these IOUs scribbled by Uncle Sam, his foreign counterparts and corporate America. Bonds still pay some interest and tend to behave better than stocks.

Since the start of last year, more than a half- trillion dollars has jammed into mutual funds that buy bonds. It’s easily the biggest new thing among small investors.

And why not?

Bond funds have been one of the few investment choices capable of pumping up a portfolio in the last couple of years. Since August a year ago, the average taxable bond fund has gained 11.4 percent, thanks largely to a surge in bond prices. By contrast, the average U.S. stock fund has earned a meager 3.7 percent and money market mutual funds virtually nothing, according to Lipper Inc.

Professional investors offer bond fund buyers one note of caution. It’s important to understand that these generally stable investments still carry their own set of risks.

Shuffling the deck

These are dreadfully unfamiliar times for a generation that marched into mutual funds during the stock market booms of the 1980s and 1990s.

The celebrations of spring 1999, when the Dow Jones industrial average first topped 10,000, have given way to the sober reality that the Dow was — yet again — crisscrossing that same mark this week.

The Dow’s April climb above 11,000? History.

The May 6 “flash crash” caught small investors and experts equally by surprise and still hasn’t been explained fully.

Federal Reserve Chairman Ben Bernanke vowed again Friday to do everything possible to support the economy, even as reported growth during April, May and June slumped to 1.6 percent instead of the originally reported 2.4 percent.

Forecasts for the U.S. economy tend to clump between “muddle through” and “double-dip recession,” adding to investor anxiety.

“Volatility is here, and it’s probably here to stay,” said Ken Green, president of Mitchell Capital Management Inc. in Kansas City.

Green suggests that investors consider trimming some of their stock holdings if it would help them sleep better. If 60 percent of a portfolio is made up of stocks, the owner might feel less apprehensive with 55 percent invested that way.

And the money moving around the mutual fund industry looks more like a shuffling of the deck than an exodus from equities.

Data from the Investment Company Institute show that investors have taken $71.9 billion out of U.S. equity funds since the start of 2009.

But they’ve plowed almost as much new money — $58.5 billion — into international stock funds during the same stretch. Stock funds focused on emerging market nations, such as China and smaller Asian countries, have done better than others.

Investors also have boosted their investments in domestic stocks through exchange-traded funds. These funds trade much like individual stocks do, allowing investors to buy and sell during the day at prevailing prices.

Investment Company Institute data for 2009 and the first half of this year show $35.8 billion more went into U.S.-focused exchange-traded funds than was withdrawn from them.

Not all that money is from small investors. But exchange-traded funds have become just as popular among individual investors as they have for pensions and other institutional investors. Advisers point out that exchange-traded funds can lower fees for a long-term investment strategy and avoid some of the tax issues mutual funds can generate.

Brian Reid, chief economist for the Investment Company Institute, said he’s not ready to declare a death knell for investor interest in U.S. stocks.

The group’s survey of investors in May 2009 did show some reduction in the risk that mutual fund investors were willing to take. But Reid said that’s exactly what he’d expect after the meltdown in 2008.

Baby boomers are aging and many likely are shifting portfolios toward less volatile bonds, perhaps making up for having ignored them in the past. This is precisely the gradual shift investment advisers recommend over an investor’s lifetime.

Still, Reid said, at this point in an economic recovery, however slow, U.S. stock funds should be attracting more money from investors than they have been. But he considers it conjecture to say that investors are somehow through with U.S. stocks.

The rush toward bond funds can just as easily be explained this way: Investors usually put their money where it performs.

“Despite disclaimers, it seems many investors do think past performance is a guarantee of future success,” said a Morgan Stanley report on Friday. “The most remarkable recent flows are to fixed income (bonds).”

Bond risks

Even if bond funds are attracting some money that might have headed toward the U.S. stock market in rosier times, they’re getting a lot more from somewhere else.

“The big source of money has been money markets,” said Jonathan Thomas, CEO of American Century Investments.

Industry data show that retail investors, excluding pension and other institutional dollars, have taken $401 billion out of money market mutual funds since the start of 2009.

And it has happened as interest rates paid by money market funds have dwindled to almost nothing. The Federal Reserve’s policy of driving down rates to lift the economy has fallen hardest on extremely short-term money market rates.

Many unrequited money market fund owners have turned to bond funds, which routinely yield a higher interest rate.

“That’s because people are reaching for yield,” said Bill Koehler, chief investment officer of ETF Portfolio Partners in Leawood. “They’re not getting paid anything.”

Savers who look only at the higher interest rates on bonds will overlook the higher risks that come as part of the deal.

Money funds are extraordinarily safe, with each share costing and selling for a dollar in all but the most extreme circumstances.

The prices of bonds and the funds that own them, however, can be pushed around by changes in interest rates. And the two move in opposite directions, as though the price is on one end of a teeter-totter and the rate of interest they yield is on the other.

As rates have fallen, the teeter-totter has boosted investors’ returns in bond funds — the 11.4 percent average Lipper reported — well above the interest they pay by pushing up the value of the bonds inside. The price gains have been greatest for bonds with the longest run until they mature.

All that would work against bond owners should the Fed begin to raise interest rates closer to normal as the economy strengthens. Rising rates would push down bond prices and potentially wipe out the amount of interest paid or more.

A quick move up in rates could turn bonds into the next disappointment for small investors.

“I wouldn’t call it a bond bubble,” said Green at Mitchell Capital. “But you need to be very careful.”

Another way investors may reach for higher interest rates is by moving away from U.S. Treasury bond funds toward foreign government bond funds or corporate bond funds. These carry higher interest rates largely because they pose a greater risk the payers will miss their payments to bondholders.

Investment advisers say they worry whether frustrated money fund investors understand these risks that come with the higher interest rates on bonds.

“That’s the $64,000 question,” Koehler said.

Better choice

There’s another reason the move to bond funds could turn into disappointment. Bonds’ big day may be near an end.

Investor fears have heightened the bidding for bonds and driven the interest they yield to unlikely low levels. Some argue that these low rates only make sense if the economy falls not only into a second recessionary dip but perhaps into something far worse.

“If we don’t, then those people (buying historically low-paying bonds) are going to be very remorseful in another five years,” said Harold Bradley, chief investment officer of the Ewing Marion Kauffman Foundation.

In his search for returns, Bradley said stocks have become the most attractive offer out there. To him, the small investor’s money is going the wrong way.

Similarly, money manager Dave Anderson at Financial Counselors Inc. in Kansas City said investors are too worried about everything and are overlooking attractive stock dividends.

Based on recent stock prices, the income dividend-paying stocks are yielding is about as strong as the interest rate yield on bonds. But the stocks have a greater chance of getting a price boost on top of the income, Anderson said.

Koehler, at ETF Portfolios, said he’s been selling bonds and buying stocks to rebalance clients’ mixtures of stocks and bonds. Bonds have been a good deal long enough to knock the mix out of balance.

Investors who are just now discovering bonds have likely missed the move.

“They’re going to be late to the party,” Koehler said.

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