Why It's Still Smart to Own Bond Mutual Funds

Last Updated Jan 5, 2011 5:33 PM EST

If you're invested in bond mutual funds, relax. The Great Bond Collapse, touted by so many noisy commentators last month, has been put on indefinite hold. Fears of ramped up inflation and spikes in interest rates were premature. Bond funds still look like sound investments, for income and diversification.

So make yourself a hot cup of herbal tea to calm your nerves and read the answers to your bond fund questions here:

Jane, the Federal Reserve is printing money. How can you say that high inflation won't follow? You'll be surprised to learn that the Fed is not printing money, although scaremongers love to say so. The money supply grew only 3.1 percent over the past 12 months, compared with a 110-year average of 6.6 percent, says Lacy Hunt, chief economist of the Hoisington Investment Management Company, which runs the Wasatch-Hoisington U.S. Treasury Fund. You can't make high inflation out of that.

Inflation fears hit the headlines because the Fed decided to push new reserves into the banking system to assist the recovery ("quantitative easing," or QE2). Interest rates rose at the end of last year, and bond prices fell.

But reserves don't become "money" until they're turned into customer deposits and loans, which isn't happening. The banks are hanging on to those funds to bolster their weak capital position (they're still writing off bad loans). If economic growth accelerates, the Fed can siphon any excess reserves out of the system. "People have overreacted," says Gus Sauter, chief investment officer of The Vanguard Group of mutual funds. "We don't see the return of high inflation yet."

Business improved last year and we got a tax cut. Doesn't that mean a stronger economy and higher interest rates in 2011? Two things drive interest rates up: expectations of higher inflation, which roiled the market at the end of last year, and an increase in economic activity. But it's far from clear that stronger growth is in the cards. The so-called "tax cut" simply kept income tax rates where they were last year, without adding any stimulus. Half of the two-point cut in the Social Security tax (to 4.2 percent, from 6.2 percent) was offset by ending the tax credit called Making Work Pay. So it won't add as much spending to the economy as you might think.

What's more, home prices keep falling. We're still losing full-time jobs; the gains are in part-time jobs. The 12-month increase in average hourly earnings fell to a cyclical low of 1.6 percent in November. State and local governments are cutting spending, raising taxes, and laying off workers. The recent rise in food and fuel prices (gasoline averages more than $3 at the pump) amount to a tax on consumers. Shoppers financed their Christmas spree by reducing their personal savings -- the savings rate fell to 5.3 percent from 6.3 percent. Instead of spending even more, families are likely to pay their bills and build their savings back up.

Jane, what if you're wrong? My bond fund lost money last month and will lose more if interest rates keep going up. Even if I'm wrong (and it wouldn't be the first time), bond funds are still a good investment for people who buy them for income. Your fund manager would be buying the newer, higher-rate bonds and passing the extra income along to you. If you reinvest the income, you'd be buying more shares in your fund at a lower price. When the business cycle turned again, and interest rates declined, those extra shares would pop in price.

Wouldn't it be smarter to switch to shorter-term bond funds? Not in my opinion. The yield curve is very steep right now, meaning that long-term rates are substantially higher than short-term rates. When the economy starts to move, short-term rates could rise fast, making these funds potentially more volatile than you think. At today's low short-term rates, you're not being compensated for that risk. Hunt is sticking with long bonds for his Wasatch fund (it returned 10.2 percent last year).

What about the risks of meltdown in the municipal bond market? Also overblown. As I wrote in a previous column, there are plenty of good muni credits available. Long-term, AA-rated muni bonds can be found at 4.8 percent, for tax-equivalent yields of 7 to 7.5 percent, depending on your tax bracket. Even the risky states are likely to pay. Debt service isn't a major part of state budgets but it's a crucial one. If they defaulted, they'd be shut out of the market and couldn't raise essential funds.

Should I switch to individual bonds, to avoid the volatility of mutual funds? I still like bond funds. Individual bonds lose money, too, if interest rates rise -- you just don't see it. But you'll feel the loss if you have to sell. The cost of investing in individual bonds in the retail market could be 2 percent or more, Sauter says (dealers often buy bonds at 98 cents on the dollar and sell them to you at 100 cents). Also, small investors take a price haircut if they sell before maturity. Low-cost bond funds are cheaper, more liquid, and better diversified. But, hey, different strokes for different folks.

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