Rate surge turning investors off of bond mutuals

As the economy warms up, investors suddenly are turning a cold shoulder to bond mutual funds.

The surge in market interest rates since mid-June has devalued existing fixed-rate bonds, sending bond fund share prices down. That, in turn, has caused some investors to stop buying the funds, and convinced others that it's time to sell.

The result: Bond funds overall had a net cash outflow of $10.8 billion in July -- marking the first time since December 2001 that redemptions outpaced new purchases, the Investment Company Institute reported last week.

July's outflow also was the biggest in more than three years. Many bond funds have continued to see cash exit in August, according to estimates from AMG Data Services Inc. of Arcata, Calif., and TrimTabs.com Investment Research of Santa Rosa, Calif. Through Aug. 20, a net $8.8 billion was withdrawn from the funds, AMG estimated.

"A lot of investors are looking at their two-month returns and going, 'Whoa, what have I gotten myself into?'" said Jeffrey E. Gundlach, manager of the TCW Galileo Total Return Bond fund in Los Angeles.

2.5 percent loss

Those losses have been relatively modest for most funds. The average fund that owns long-term bonds had a negative total return (interest earnings plus or minus change in market value) of 2.5 percent between June 30 and last Friday, according to fund tracker Lipper Inc. in Denver.

But some funds that focus on the longest-term bonds have racked up drops in market value nearing double digits over the last two months, as interest rates have jumped.

"It's one thing to lose 10 percent or more when you're buying eBay stock and hoping to double your money," Gundlach said. "But when you're buying a Treasury fund and only hoping for about a 10 percent return, that's something else."

The share price of Gundlach's fund is down about 2.2 percent since June 30. It's all a dramatic turnaround for bond funds, which had taken in record sums over the last 2 1/2 years. The funds reaped net inflows of $140 billion in 2002 and $67.7 billion in this year's first half, according to institute data.

Falling interest rates since 2000 boosted the value of older bonds and gave many investors an incentive to lock in yields.

What's more, the stock market's plunge for much of the period left many investors anxious to funnel their money into safer securities.

Now, bond investors are reacting not only to recent poor returns, but also to the prospect of the Federal Reserve raising interest rates in 2004 to keep the U.S. economy from overheating, market strategists say.

"We've had three years in which so-called safe assets such as bonds have outperformed 'risk' assets, meaning stocks, but that won't continue forever," said Bill Hornbarger, fixed-income strategist at brokerage A.G. Edwards & Sons Inc. in St. Louis. "In my opinion it is much more difficult to be an income investor than a growth investor right now."

'Scrape away your gains'

Though analysts often chide small investors for "performance-chasing," some say shifting money away from fixed income assets may make sense these days, especially for those who are underweighted in stocks.

"If over the past three years you've let your profits ride on bond funds, it probably makes sense to scrape away your gains and put them into equity funds," said Andrew Clark, senior research analyst at Lipper.

But analysts say it's also important to put bonds' situation in perspective.

Year to date, the average bond mutual fund still is posting a positive total return. The giant Pimco Total Return fund, for example, is up about 1.1 percent, as measured by its class-A shares.

For investors who need regular interest income -- and relative safety of principal -- bond funds still may make sense, many experts say. As market rates rise, bond fund yields eventually will go up as well as the portfolios reinvest in newer securities.

But history shows that when interest rates rise and bond fund share values fall, many investors flee. That happened in 1994, when the Fed doubled short-term interest rates.

Bond funds also suffered heavy outflows in late 1999 and in the first half of 2000, when market rates were rising.