The stock market got some revenge in the third quarter — but the bond market still got the money.
Share prices rebounded sharply from their spring losses as fear of another recession eased and the Federal Reserve pledged to pump more cash into the economy if needed to bolster growth.
The average domestic stock fund surged 10.5% in the three months ended Sept. 30, according to Morningstar Inc. Foreign stock funds posted even bigger gains.
But many investors haven't been riding the equity market's latest wave. U.S. stock funds have been suffering net redemptions for most of the last year, and the outflow of money from the funds accelerated in the latest quarter.
Investors pulled a net $39.2 billion from domestic equity funds in the last three months, or about 1.1% of total assets, up from a $21.5-billion outflow in the second quarter, industry data show.
By contrast, an avalanche of money continues to pour into bond funds, the public's clear favorite investment since early 2009. Bond funds had net inflows of $86.4 billion last quarter, up from $63.5 billion in the spring period.
Bond fund returns mostly lagged stock fund returns in the third quarter, but bond investors can't complain: Most fixed-income funds were up between 3% and 6.5% in the period, counting interest earnings and capital appreciation, as another steep drop in market interest rates made existing bonds more valuable.
What's more, in the first nine months of this year the average bond fund beat the average equity fund, although a rally in stocks last week narrowed the performance gap.
But the better things get for bonds, the louder are the warnings that investors may have been lulled into a false sense of security — a feeling that they can't lose money in fixed-income investments, or that bonds' returns over the last two years can go on indefinitely.
The continuing slide in interest rates, as the U.S. economy has struggled and the Fed has kept its benchmark short-term rate near zero, has left many Americans starved for investment income from traditional low-risk sources, such as bank savings certificates and money market mutual funds.
That has made the low- to mid-single-digit yields on bonds more alluring.
With short-term interest rates so paltry in much of the developed world, the hunt for income has become a global affair. That has played to the advantage of many companies and countries looking to borrow at relatively cheap rates via bonds.
Just last week the Mexican government issued $1billion of bonds at an annual interest rate of 6.1%. The most striking thing about the sale: Mexico locked in that rate for 100 years. The bonds mature in 2110.
"The danger is that people are so desperate for income, they're taking on more risk than they understand," said Miriam Sjoblom, who tracks bond funds for Morningstar in Chicago.
Bond investors have heard that before. But the lower interest rates get, the more the math undeniably works against bond owners.
Consider: The Pimco Total Return bond fund, the world's biggest, gained 9.5% in the first nine months of the year. But 7.4 percentage points of that return was from appreciation of the fund's share price as its bonds rose in value because market interest rates fell. Interest earnings on the fund's bonds accounted for the other 2.1 percentage points.
To put it another way, if market rates had held steady in the period, the Pimco fund might have earned only that 2.1%, depending on how fund chief Bill Gross managed the portfolio.
And if market interest rates had jumped instead of falling, devaluing the fund's bonds, the drop in the fund's share price might have more than offset the interest earnings, at least on paper.
With average annual interest yields under 5% on many funds that own high-quality bonds, it wouldn't take much of a backup in market rates to wipe out most of that interest return.
"There's not a whole lot of yield left out there," said Jeff Tjornehoj, senior research analyst at fund tracker Lipper in Denver.
Yet bond market bulls note that the Federal Reserve may soon try to drive longer-term interest rates even lower: Fed policymakers have signaled they're considering a major new program of buying Treasury bonds, hoping to put downward pressure on interest rates across the board to help bolster the economy.
Rather than try to predict Fed policy and its success or failure, most bond fund investors probably would do better to make sure they have a basic understanding of what they own and the potential rewards compared with the risks.
Start with this checklist:
• Try to assess how much principal risk you're taking. If you own a bond fund, the one number you need to know is the fund's "duration," which measures the portfolio's sensitivity to market interest-rate swings.
