Bond funds: Why they're risky -- and why they're safe

Bond funds have been a popular investor choice in recent weeks, but some investment gurus warn of a bond-fund bubble that will burst. Here's the case for and against bond funds.

Investors poured money into bonds Tuesday, as worries about the economy battered the stock market.

The rush into bond funds amplifies a trend that's been largely in place since the financial crisis began, but it raises an important question: At this point, are people playing it safe or risky when they emphasize bonds over stocks in their retirement funds?

Some investment gurus warn of a bond-fund bubble that will burst – hitting US Treasury bonds hardest of all – perhaps within the next year. A rival camp sees the big risks in stocks in the near term. Given the uncertainty, a middle-ground view emphasizes the virtues of a balanced mix of bonds and stocks.

Mutual-fund investors continue to vote with their feet for bonds. In each of the five weeks ending Aug. 11, they poured more than $6 billion into bond funds. And in each of those weeks, investors were pulling money out of stock mutual funds at a rate of $1 billion to $4 billion per week, according to the Investment Company Institute in Washington.

On Tuesday, falling home sales and other signs of economic weakness sent stock prices falling and prompted an investor rush toward bonds. The yield on the 10-year Treasury note fell to just 2.5 percent, the lowest since early 2009. (The yield on a bond falls as its price rises. In effect, rising demand means that investors are willing to settle for a smaller stream of income.)

Here's the case for and against bond funds:

Why bond funds are risky

Although bonds are less volatile in price than stocks, they can fluctuate considerably at turning points in the economy. If the economy turns up, even just enough to clearly avoid a "double dip" recession, bond prices could suffer as investors begin to gravitate back toward the stock market.

It's hard to predict when a shift will occur, but at some point, many investment strategists warn, Treasury bonds will become the worst-performing bonds of all. That's precisely because these bonds are considered to be among the safest investor havens during hard times. If a crisis mind-set eases, Treasuries have run up so far in price that they have the furthest to fall.

"The US is in the midst of a sharp but temporary slowdown that will give way to stronger growth later this year and into 2011," Michael Darda, chief economist at the investment firm MKM Partners, wrote in a note to clients Monday. That makes him bullish on stocks.

A revival of inflationary pressure would pose another worry for bonds. Interest rates might rise as investors demand a higher return to compensate them for inflation. The prices of existing bonds would adjust downward accordingly.

One example of how vulnerable bond funds can be when the mood toward bonds shifts: The Fidelity Government Income Fund, which invests mostly in US government bonds (ticker symbol FGOVX), saw its share price fall 13 percent during a six-month period starting late in 1993. The sell-off in bonds came just before a period of massive gains for stock investors.

Since the onset of the financial crisis in 2007, a Barclays exchange-traded fund that tracks long-term US Treasury bonds has gained more than 20 percent in value. This bond fund (ticker symbol TLH) has risen so sharply since March that it's currently near the peak it reached at the end of 2008.

Why bond funds are safe

The bullish view is that bond funds have risen for a good reason: The outlook for the economy has grown worse than investors had foreseen a few months ago. Although US stocks have lost more than 10 percent of their value since April, they could easily fall a lot further if the economy keeps getting worse.

Treasury bonds, the same ones that critics say are in a bubble, tend to perform the best during a crisis. Put another way, even though stock and bond prices can often move in the same direction, Treasuries tend to be more protected from a stock bear market than, say, corporate bonds are.

The bond-bull camp doesn't foresee a big sell-off in bonds until the economy mounts a strong recovery. And in its view, that could take more than a year. In the meantime, bond investors will earn at least a modest income – more than they could get in money-market mutual funds that are often yielding nearly zero percent interest.

In this view, inflation won't get going anytime soon. That's because the economy's troubles stem from over-indebted consumers, troubled banks, and a government that may be running out of stimulus options. In other words, this hasn't been a garden-variety recession and won't be a typically strong recovery either. (Inflation tends to appear during a robust recovery.)

What about when an economic recovery does kick in?

Bonds won't tank overnight. Even if investors do experience a bear market in bonds, some research offers a brighter view of what occurs: If bond-fund investors stay the course, argues a report issued by Vanguard, a big provider of mutual funds, the losses in portfolio value if bond prices fall would ultimately be offset by rising income from their bond funds.

Of five hypothetical scenarios that Vanguard researchers examined, the one with the biggest shareholder loss in the short term (one year) was also the one with the highest annualized returns over a 10-year period.

Follow the bond bulls, bears, or both?

Both sides in this bond-fund debate have some strong arguments. One option for investors is not to side wholly with either camp.

To many investment strategists, the prudent course for people saving for retirement is to hold a balanced mix of stocks and bonds. It's a classic view, based on the notion that stocks have provided stronger returns than bonds during most periods, while bonds add some stability without dragging long-term performance down too much.