Morningstar Advisor - June/July 2010 - 34

Spotlight

Some People Are Bullish on Bonds
By Sonya Morris

Ignoring looming risks, investors pour assets into fixed-income funds. But will they stick around after the first sign of trouble?

Weighing in at almost $220 billion in assets, PIMCO Total Return Bond PTTRX is the largest mutual fund in the world. As its popularity continues to soar, it’s become the mutual fund equivalent of the iPhone. Over the past 12 months ended March 31, it has taken in an amazing $53 billion in new flows. That’s enough to swallow all of First Eagle’s mutual fund assets and have enough left over to consume Calamos for dessert. PIMCO Total Return’s story provides a dramatic illustration of a trend that’s been going on across the fund world: Investors just can’t seem to get enough of bond funds. Fixed-income offerings at almost every fund house have gathered assets by the fistful. Investors have preferred bond funds over equity offerings for more than two years now, and by a wide margin. In 2009, U.S. open-end bond funds took in $357 billion, more than all the other asset classes put together. They have continued to dominate flows in 2010, gathering another $88 billion in the first quarter. For perspective, fixed-income funds took in more flows in 2009 than they saw over the previous five calendar years combined. A couple of factors explain this stampede. Low yields in other income-producing investments, such as money market accounts and bank CDs, likely pushed some income-hungry investors into bond funds. In addition, after experiencing harrowing losses in 2008, many investors may have reassessed their capacity for risk and

increased their portfolios’ allocations to lower-volatility asset classes. However, bond funds aren’t immune from volatility. In fact, there are risks looming on the horizon that many new shareholders may not fully appreciate. If these risks reveal themselves, it could test the patience and loyalty of these newfound bond investors, particularly if their expectations are unreasonable. Here are a few areas to watch.
Credit Worries Hang Over Muni-Bond Funds

seen tax revenues decline just as the demands on their resources are increasing. To top it off, these credit-quality worries are rising to the surface after muni-bond insurance has faded to the background. Fund managers we talk to aren’t expecting massive defaults, but downgrade risk is a real concern. If credit-quality issues overshadow the positive technical backdrop, muni-fund shareholders could be in for some volatility. The risk may be the greatest for short-term muni funds, which captured nearly half of the flows into munibond funds in 2009. That rush of cash helped push valuations of short-term munis to lofty levels, leaving them vulnerable to the slightest hint of bad news. These funds are not immune to losses over the short run, and that could test the staying power of those who turned to short-term muni funds in lieu of money markets.
Bond Index Funds Face Headwinds

Taxable-bond funds accounted for most fixed-income flows in 2009, but muni funds had a banner year, too, gathering an unprecedented $72 billion in assets. That blew away the previous record of $21 billion in 2006. The same factors that have fueled flows into taxable bond funds also buoyed muni-fund flows. In addition, many investors have turned to tax-conscious funds in anticipation of higher tax rates in 2011 and beyond. Those demandside factors will likely continue to work in favor of munis in 2010. At the same time, supply will be limited as the Build America Bonds program makes it more attractive for traditional muni issuers to gain financing via the taxablebond market. Those technical factors could support muni bonds in the coming months. On the other hand, storm clouds are brewing over state and municipal governments. They’ve

A noteworthy amount of inflows went to bond index funds, most notably Vanguard Total Bond Market II VTBIX and Vanguard Total Bond Market VBMFX, which took in almost $23 billion combined in 2009 and almost $5 billion in the first quarter of 2010. Index funds are designed to provide broad, diversified exposure to an asset class. For the most part, they do exactly that. But bond index funds, many of which track the Barclays Capital

34 Morningstar Advisor June/July 2010

Morningstar Advisor - June/July 2010

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