Investors focus on bonds despite a big stock rebound

By Tomoeh Murakami Tse
Washington Post Staff Writer
Sunday, January 10, 2010

NEW YORK -- Small investors, still jittery even as stocks roared back to life from the financial crisis, are turning back to the market looking for less-risky ways to reboot their portfolios.

Many mom-and-pop investors who dumped stocks throughout the downturn have remained wary, content to sit on the sidelines as the Standard & Poor's 500-stock index soared 65 percent from its lows in March to ring in the new year. But instead of buying back stocks, individual investors have increasingly poured their money into bonds, which are considered to be safer but could pose risks in 2010.

Investors in mutual funds, a popular way for small investors to access the markets, pulled roughly $250 billion from stock funds during the market downturn from October 2007 through March, according to the Investment Company Institute. During that 17-month period, managers of money-market funds saw a hefty $933 billion inflow as investors sought safety. Just about every investment was ravaged, including mortgage securities and stocks in emerging markets.

Although signs of an economic recovery began budding in spring, nine months later, retail investors have yet to jump back into stocks in full force, instead steadily putting money into bond funds in ever-larger sums.

With the damage to their retirement accounts still a recent memory, many small investors who have been sitting on their cash perceive investing in bond funds as "dipping your toe back in the pool," according to Rebecca Schreiber of Solid Ground Financial Planning in Silver Spring. "I think this is how people are reintroducing themselves to the market."

There is also some chasing of past performance, analysts said, with investors pulling out of money-market funds earning near-zero interest to go after returns in bond funds, which returned an average of 13.5 percent for the year, according to Lipper, a data company that tracks mutual funds. Equity funds, meanwhile, gained an average of 34 percent.

But fund investors hoping for similar gains in 2010 will probably be disappointed, analysts say. High-yield bond funds, which invest in the debt of riskier companies with non-investment-grade ratings, were trading at average discounts of 50 to 60 cents on the dollar at their lows last year. They are now back up to trading in the 90 cents on the dollar and up, according to Ken Taubes, head of U.S. portfolio management at Pioneer Investments in Boston. High-yield bond funds returned a whopping 46 percent on average last year, according to Lipper. They are up nearly 4 percent over a two-year period.

"Returns will be greatly reduced from last year but still reasonable," said Taubes, who expects high-yield funds to return somewhere between the high single digits to the low teens for 2010.

"All those really big historic bargains are gone," said Miriam Sjoblom, senior bond fund analyst at the investment research firm Morningstar.

Analysts also warn that bond investors may be in for a rude surprise when interest rates, which are at historical lows, eventually head back up. In general, bond prices take a tumble when interest rates rise and rally when rates fall. The Federal Reserve has kept its short-term interest rates low in an effort to support the economy.

"Right now, interest rates are artificially low because the Federal Reserve has pumped so much money into markets," said Mark Coffelt, chief investment officer of Empiric Funds. "They're deliberately doing that to get the economy back on its feet. But at some point, they're going to have to get rates back up because they don't want inflation. I think there are going to be a lot of investors shocked at how fast those bond funds can go down when interest rates go back up."

To be sure, few expect the Fed to increase rates anytime soon. The Fed said at its most recent policymaking meeting, in mid-December, that it would probably keep its target interest rate very low for an "extended period." While the central bank said it is pulling away from some of the emergency measures it put in place during the crisis, the Fed is still concerned about the weak U.S. economy and is unlikely to raise interest rates until it is on more solid footing. On Friday, the Labor Department reported that the nation lost 85,000 jobs in December, worse than expected, prompting President Obama to lament that "the road to recovery is never straight."

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