Interest rates have been so low for so long that investors may not be prepared for the long rally in bonds to end, many fund managers, financial advisers and bond traders say.
"The folks who are chasing returns in bond funds are in trouble," said Roger I. Bair III, senior portfolio manager at PSA Financial Center, a financial management company in Lutherville, Maryland.
He added that "the cyclical trend" in interest rates that lowered bond yields and raised bond prices was nearly over. "Going forward," he said, "things will be very different for bond fund managers."
Investors have flocked to bonds during the bear market in stocks. According to the Investment Company Institute, the trade group for the mutual fund industry, taxable bond fund inflows exceeded US$120 billion last year, a record. In the first quarter, the surge continued, with an estimated US$45 billion flowing into taxable bonds, according to AMG Data Services.
But interest rates, hovering near their lowest levels in decades, are likely to rise once the economy strengthens, lowering the price of bonds and hurting the returns of bond mutual funds.
Concerns about the economy have weighed down the bond markets over the last month, and interest rates have been little changed since the start of the war in Iraq. The yield on the benchmark 10-year Treasury note has fallen slightly to 3.96 percent, from 3.98 percent on March 19, when the war began, modestly raising the bond's value. Whether that trend will continue in the short run is far from certain, but most advisers and portfolio managers say yields will probably rise, and prices decline, over the longer term.
Bond fund investors can prepare by making sure that their asset allocation is appropriate for the long term, many financial advisers say. After three years of strong returns, the bond portion of many portfolios may be too heavy.
After checking the allocation, investors should make sure that they are holding appropriate bond funds, said Sue Stevens, director for financial planning at Morningstar.
Those who have their money in a total-return bond fund -- a general-purpose bond fund that allows managers considerable leeway in selecting the type and duration of bonds -- will have to trust the fund manager to adjust the fund's holdings of specific bonds.
In the current economic climate, Bair said, managers are likely to sell bonds with longer-term maturities because longer-term bonds are most sensitive to interest rate shifts. If managers anticipate rising interest rates, they generally shorten the average maturity of the bonds in their funds. If interest rates rise sharply, such adjustments are likely to minimize losses, though not eliminate them.
The largest total-return fund is Pimco Total Return, with more than US$70 billion in assets. Over the last three years through Thursday, it returned 9.93 percent a year, on average, about 1.6 percentage points better than its peers.
Other large total-return bond funds recommended by advisers include Dodge & Cox Income, which returned 10.34 percent, annualized, over the period; TCW Galileo Total Return Bond, 10.71 percent; and BlackRock Core Bond Total Return, 9.07 percent.
People who prefer making more of their own investing decisions may have loaded up on funds filled with long-duration bonds, which are more sensitive to interest rate shifts. Those investors may want to consider shifting to short-duration bond funds, Bair said.
"The ones to avoid are the long-term Treasury funds," he said. "But one of the things that surprises me is how few people got out of these funds during previous periods of rising rates. You need to get out of them now, before they decline."
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