MANY of the investors who rushed into bond funds as stocks stalled over the past two years could be in for an unpleasant surprise soon.
The price of their funds may take a beating.
That's not a warning designed to get you out of bond funds, just a wake-up call for what first-time buyers are about to experience next in the normal cycle of bond investing.
Anytime interest rates reach an inflection point - where they start to reverse direction - things get interesting for bond funds.
Bond funds have to "mark to market" every day, meaning their shares are priced based on the value the bonds would bring were they sold on the open market. Bond prices also tend to go in the opposite direction from interest rates: When rates go up, bond prices fall.
So let's say the Federal Reserve's recent decision to hold the line on interest rates is a sign that the tide is turning, which many observers believe. When rates move up - which some are expecting to happen in the second quarter of this year - bond prices will fall, taking bond funds with them.
Long-term bonds feel the impact of rising rates most sharply, while short-duration funds may scarcely see a blip.
"A lot of people who rushed into bond funds because their stock funds were doing poorly will now see rates reverse themselves, which may convince some of them that their new bond funds stink too," says Stephen M. Savage, editor of the No-Load Fund Analyst newsletter. "So long as people understand what's happening and manage their expectations properly, they'll be fine. But if they look only at the current price, they may get scared."
Ironically, even as a bond fund's share price falls, the rising interest rates may increase the fund's yield, keeping its total return - dividends and income plus any appreciation or minus any loss - steady or even making it go up.
Total return is the number at which investors should look when evaluating a fund's performance, but it can be difficult to keep your eye on the ball when a fund appears to be headed for a fall.
"People who bought bonds not as a safe haven but because that's where the bigger returns have been are going to feel like they are out of the fire but in the frying pan," says Don Phillips, managing director at Morningstar Inc. in Chicago. "The fire was the Internet stocks and tech stocks, which burned them, but the frying pan is what they will feel like when their bond fund values go down."
Obviously, savvy investors who have lived through interest rate inflections while holding bond funds are used to the ebb and flow.
Market-timers - the people who bought bond funds in order to chase the hot sector of the market - are already thinking about the right time to bail out and move back toward growth stocks.
It's the people who bought bond funds thinking they wouldn't see their share prices fall who could be in for a shock.
The situation affects investors whether they own individual bonds or bond funds.
Say you're holding an individual bond when rates go up. The bond keeps paying you until you get the return promised when you bought it. If at any time you needed to sell it, however, the present value of the bond has been reduced. Why? Because buyers aren't getting the top-dollar yield on your bond that they could get on something newer with a higher yield.
Says Mark Riepe, head of the Schwab Center for Investment Research, "Bond funds have no choice but to act as if everything in the portfolio is being sold at the end of every day. It doesn't reduce the credit quality and it shouldn't make investors too worried, but everyone gets nervous when they see things start to fall."
If interest rates do go up and bond fund prices decline, investors will learn another key lesson about these investments: Expenses matter more here than with practically any other type of fund.
Unlike stocks - where there are many different investment styles that a manager can follow - bond funds within a category tend to be run in a similar fashion. What separates the leaders of a category from the laggards typically is expenses.
With the average bond fund carrying an expense ratio of about 0.85 percent, investors who are worried about how their bond fund might do when rates increase should probably take a look at costs now. If your fund's expenses are above average, its total return is likely to be below average.
Notes Savage: "It's important in times like these to manage your expectations. Don't get too negative, just understand that interest rates will go up and that bond prices will fall and that it's normal. ... If the last few years taught you of the importance of holding bonds, the next few months or years when rates may go back up shouldn't scare you out of them."
Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at firstname.lastname@example.org or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.