Individual investors often are accused of chasing performance--that is, piling into whatever market sector has been hot in the immediate past.
That's a problem the bond mutual fund industry would love to have this year.
High-quality bond funds are on track to turn in their best performance since 1995. And barring a dramatic stock rally between now and year's end, the average bond fund will outperform the average stock fund this year for the first time since 1990.
Yet investors, on balance, have continued to yank money from bond funds all year. Through October, a net $32.6 billion has poured out of taxable bond funds, a category that includes government-bond and corporate-bond funds. A net cash outflow is the excess of investors' redemptions from funds over new purchases by other investors.
Tax-free municipal bond funds, the biggest stars in the bond fund universe this year in terms of gross performance, also have failed to attract new money, on balance: The year-to-date net cash outflow from muni funds through October was $15.7 billion, according to the Investment Company Institute, the funds' chief trade group.
Those net outflow figures aren't a pittance compared with the total assets of these fund sectors. For both taxable and tax-free bond funds, the outflows so far represent about 6% of each category's assets at the start of the year.
You can imagine how it feels to be a bond fund manager this year. While the average stock mutual fund is up a mere 0.6% year to date--and technology-stock funds have lost 20% or more--many bond funds have produced total returns in the vicinity of 10%. So bond funds have played their traditional role as a relatively safe haven for investors' capital in times of market turmoil.
Yet stock funds, on balance, still are taking in net new cash (a record $291 billion for the year, through October), while bond funds' reward for making money this year is net redemptions.
There are some good reasons many investors remain unappreciative of bond funds, which we'll get to soon. Still, those who believe bonds are unnecessary, unexciting or simply uncool in the context of a diversified investment portfolio may want to reconsider in the wake of this year's performance results and what those results may portend for this decade.
Investors who were around in the 1980s remember that it was a great decade for stocks, beginning in 1982. Yet bond funds far out-classed stock funds for most of that decade in terms of total assets.
From 1984 through 1990, bond fund assets ballooned from $46 billion to $291 billion. In that same period stock fund assets rose from $83 billion to $240 billion.
Fund investors liked bonds because the returns were spectacular. The 1980s started with record high interest rates to match the record-high inflation of that era. But as inflation came down in the '80s, so did interest rates, including on bonds. That generated tremendous total returns on bonds.
What, exactly, does "total return" mean?
Say that, in 1982, you bought a fixed-rate, 10-year bond that paid 13% annual interest. So you were assured of earning that 13% a year until the bond matured, unless the issuer defaulted.
As yields on newly issued bonds fell in the '80s, your 13% bond naturally became more valuable. Thus, its market price rose, generating a principal gain that was gravy atop your already-handsome yield.
In the 10 years ending Dec. 31, 1990, the average bond mutual fund that owned high-quality corporate bonds produced a total return of 210%, according to Lipper Inc. That topped the 202% return on the average stock mutual fund in that period. No wonder investors loved bond funds.
In the early 1990s, as market interest rates continued to fall, the number of bond mutual fund accounts continued to zoom, even as stock fund accounts surged, too.
But everything changed in 1994, when the Federal Reserve began to tighten credit dramatically, causing short-term interest rates to double and sending long-term rates up as well.
Investors who had piled into bond funds learned that "total return" in the bond market cuts both ways: If you're holding a long-term bond yielding 6%, and newly issued bonds yield 8%, your older, lower-yielding bond obviously is going to be worth less in the market.
So the bond's principal value falls, which is subtracted from whatever interest you're earning on the bond to show your net, or total, return.
Note that it isn't a question of getting the interest that's owed to you--you still earn that. And if you don't sell your bond, or bond fund, you don't officially have a principal loss. But it's there, nonetheless, in this case; total return tells you what you truly have earned, or lost, on a bond, interest earnings and principal change combined.
Many investors who bought bond funds in the early '90s clearly didn't understand the idea of total return. They thought bonds never lost money. But if market interest rates are rising, bonds can indeed lose money, at least on paper.