After Record Flows, Are Bond Funds a $360 Billion Bubble?

It's no secret that investors flooded bond funds with cash last year, raising the dreaded specter of a bubble in the fixed income market, and the latest annual data from fund researcher Morningstar only serves to underscore those concerns. U.S. open-end bond funds took in $357 billion in cash last year. That's not only far more than any other asset class in 2009, but more than bond funds took in over the previous five years combined.

Several factors explain this stampede, writes Morningstar analyst Sonya Morris, including paltry yields on money markets and certificates of deposit, as well as some good old -- and possibly dangerous -- performance chasing. It also helped that bonds held up better than most other asset classes in 2008 and outperformed stocks for the decade. But perhaps most important is that after the harrowing losses of 2008 many investors probably reassessed their capacity for risk and moved into lower-volatility asset classes.

That could be a mistake, Morris warns. "True, bond funds can serve to smooth out total portfolio returns; however, they aren't immune from volatility," the analyst writes. "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 new-found bond investors, particularly if their expectations are unreasonable."

The Fed Changes Its Tune

One of the bigger threats to bond funds in the shorter term is that the prices of agency bonds and mortgage-backed securities from the likes of Freddie Mac and Fannie Mae have been artificially lifted by the Federal Reserve -- but the Fed is scheduled to end its buying program this month. Farther out, of course, is the inevitable interest rate hike. Higher-quality bonds such as Treasurys and agency debt are more vulnerable to rate hikes than lower-rated bonds, so the rate hike will pressure those prices more than, say, riskier junk bonds.

And, not to be forgotten, a rate hike could make the yields on CDs and money markets more competitive with bonds, putting further pressure on prices as investors flee for more liquid accounts. "That could shake out investors who don't have realistic expectations about bond-fund volatility," Morris writes.

The last time the fixed-income market experienced a downturn coincided with the bursting of the dot-com bubble, Morris notes. From September 1999 through December 2000, nearly $58 billion flew out of bond funds, "but they quickly made up that lost ground in 2001 and 2002 when investors once again sought shelter from the crumbling stock market," Morris says.

"A downturn in the bond market will likely cause some shareholders to dump their bond funds, but the level of outflows will depend on the factors that have driven investors to the asset class in the first place," writes Morris. "If fixed-income funds manage to limit volatility relative to other asset classes, they stand a good chance of holding on to their shareholders. Only time will tell."