It's 2011: Do You Know Where Your Bond Mutual Fund Is?

Almost every investor in the country owns a bond. This ownership might be via bond mutual funds, investments in individual bonds be it corporate, government or municipal, or through the widely used target date funds. Each is prone to its own troubles.

Bond mutual funds, even though they are managed by expert managers, may be so burdened by the underlying investments as to hide or mask the trouble that may be brewing in this market.

Individual bonds are influenced by the health of a company, the ability of the government to retain its high credit rating or in the case of the municipality, pay off the debt it is owed to those who invested.

Target date funds, the darling of the auto-enrolled 401(k) participant may contain the most trouble in part because you don't have a good bead on what is owned and in many cases, in what proportion.

There are some essential elements of a bond that many simply do not grasp to its fullest. Not the least of which is the effect that interest rates have on these investments. In short, bonds are loans and the way these borrowers pay you back is with the agreed upon interest. Many bond issuers simply refinance those bonds to pay that interest. But what if the interest rate isn't favorable to such financial restructuring?

So let's talk interest rates for a moment and some of the assumed beliefs you may have.


The trickle up effect
We often put a good deal of the emphasis on the Federal Reserve bank and their presumed control over all interest rates. They lend to the largest banks in what is called an overnight rate. Banks increase that rate to consumers at each level of lending, the last rung being the consumer loan for a mortgage or a personal loan.

Those rates are determined by demand, the market forces at play and in many instances, inflation and/or governmental budgetary needs (deficits). The Fed looks at money supply, the other half of the demand equation and depending on how much is circulating - too much and the interest rates remain low, too little and they increase. Sometimes.

Sometimes fear increases those rates as well. Growth forecasts and a strengthening economy normally lead to more demand for capital which leads to higher interest rates. Add to that the increasing possibility that inflation will rise as well. gives everyone who borrows the jitters. They know, should these things happen, the Fed will raise interest rates in the name of stabilizing the economy.


The emerging market conundrum
The world is global - while an oxymoron as a stand alone phrase, it represents a growth not previously seen in the decades prior to this one. Emerging economies are building at a pace that is much faster than anyone anticipated. Much of this growth is coming from China but there are numerous other economies doing the same thing on a slightly smaller scale.

The flip side of that growth is investment and investment needs money and countries, faced with growing populations who no longer worry about saving, instead shifting to spending, force borrowing. This will increase interest rates - probably sooner than we expect. many of us have experienced low interest rates for so long, we consider it to be the norm.


Consumers: should you save or should you spend?
The most common answer is to spend. Popular economic theory is that if consumers fail to spend, the economy will languish. This is actually not the whole truth. If interest rates are low, it would pay for infrastructure improvements much more cheaply than otherwise - and these improvements are necessary if corporations expect to become more efficient in their production of goods and services.
The bottom line, a healthy savings rate actually adds to the improvements that need to be made. It doesn't suggest that folks won't spend. But it does prompt companies - at least in theory to do a better job enticing you to do so.


Is mortgage deductibility important?
Possibly but the impact is lower and more specific than many suggest. Lower interest rates on home loans entice borrowers to buy more house than they need, refinance to increase their debt and those actions pour more money into the economy. Yet at the same time, estimates of lost revenue to the federal government have been estimated to be as high as $104 billion a year.


Raise those interest rates
No doubt, we expect interest rates to remain low. But they should be inching up. According toRichard Dobbs, director in McKinsey’s Seoul office and a director of the McKinsey Global Institute (MGI) and Susan Lund is director of research at MGI, higher interest rates would "also limit financial bubbles, restraining speculative and heavily leveraged investment while encouraging more investment that would actually raise the economy’s potential growth rate, such as expanding the country’s broadband network, developing new green technologies, and rebuilding aging infrastructure."

The authors of that report also suggest, a rightly so, that "higher rates would also focus executives’ attention on the return that companies earn on their capital, prodding them to make sure they get more bang for each buck. This could boost the nation’s productivity, which is the key to raising standards of living over time."

Does this point to a bond bubble?

Not necessarily so. What it does however is seduce investors into thinking that all is well and bonds do not come with risks. Gus Sauter, chief investment officer of The Vanguard Group, the largest U.S. bond mutual fund manager with $413.6 billion of fixed income assets as of Dec. 31 wrote that he is "increasingly worried that people aren’t aware of the risks in the bond market. The problem is that when you’re at historically low rates, as we are now … yields aren’t likely to go significantly lower, and at some point when the economy does strengthen, they’re likely to push higher.”

This does suggest that bond investors are overbought, denying the risks involved and ignoring the potential, even probable readjustment in this corner of the market. Will it burst as a bubble might? Not likely but the slow hiss will take the least experienced investors by surprise and it may be too late by the time it happens for them to do much of anything.

With one exception, possibly two. Increase your equity exposure is one. The other, buy short maturities. This last one might make it difficult for individual bond holders to ladder their portfolios. But at least you won't be stuck with bonds that are worth less in an inflationary period.

Closing the Doors on Return Chasers: Mutual Fund Inflows Create Problems

Like a torrential downpour can overwhelm gutters, flood streets and generally create the kind of havoc only water can, too much money flowing into mutual funds can also leave a mark on both new investors and those of record.

Now that the markets seem to be hellbent on leading the recovery (although there is still a popular consensus that this is not the real thing without jobs and earnings that are built on growth rather than cost-cutting), you have to wonder what is going on? Why is being asked quite frequently these days and many of the answers point to too much money on the sidelines suddenly feeling better about the opportunities and the fear of missing the recovery.

Investors who may have sold their stakes in funds that had done well for them in the past and then hurt them dramatically over the last part of 2008 are eyeballing this return to glory, ignoring the recent past at little more suddenly that I would have anticipated they would. Rushing back into the market is not what mutual funds need right now.

The Upside is the Downside
When investors flee, the remaining shareholders pay the price of staying. There are transaction costs and taxes to be paid (if the fund is forced to sell winning stocks to pay for redemptions) that are left for the fund to pay, passing on those costs. But those shareholders might benefit in the long run if their fund has positioned itself for the recovery. In fact, many investors are finding that staying put has them very close to the even point of where they closed the 2007 investment year.

But the problem with this rush is that it too causes an increase in costs for transactions and creates the possibility that too much money chasing too few stocks begins to artificially inflate those shares and we are off to the bubble races again. Some funds are so narrowly focused that the securities they need are being overbought.

This leaves investor money on the sideline, the exact place that it was before but no longer is. So fund managers are beginning to, at least temporarily close some of the hottest funds with the best year-to-date or quarterly returns. While this doesn't have any effect on shareholders currently in the fund, the problem of a deluge of new investors does not go away; it simply goes somewhere else.

This is especially problematic in the case of bond funds. Chasing performance while eluding risk is what bond investors have always sought. That and a return of their investment. Unless you own individual bonds, and plan on holding them to maturity, you may be unwittingly facing the same problem that mutual fund bondholders might be facing. Credit markets are still tight, the dollar is still weak and the economy has not yet fully embraced the enthusiasm of the stock markets. This makes bonds risky and increases the chances of default (which you will see in the increased yields).

When Fools Rush In
Overexposure and increased investments push bond prices higher and make profitable yields harder to find. This in itself, creates risk that many conservative and asset protection minded investors may not be willing to (or knowingly) assume.

At the same time, an opposite problem is looming for fixed income investors. Bonds are poised for difficulties in the coming years as inflation begins to rear its ugly head and deficit spending, necessary to facilitate the recovery begins to whittle away the current returns. For these investors, what would seem like a win-win situation might turn out to be something entirely the opposite.

Balanced funds and lifecycle funds may also be facing similar dangers as they try to increase bond exposure over time but are finding the endeavor more expensive than they would like. With fewer desirable bonds to purchase, these managers may be left with taking on more risk than the stocks in their portfolio have.

This imbalance could lead to more problems in the near term as investors seek out underinvested corners of the marketplace. The return chaser will simply head (or better, herd) for whatever is available. And a new cycle begins. Despite whatever notion of moving to a lower risk portfolio might provide, long-term investing still points to stocks as a safer haven. Which stocks is open for debate and future market gyrations. Yet, as fixed income portfolio managers try and warn their shareholders that this recovery is unlike any other, those looking for the safest of havens might not find what they are looking for in bond funds.

Paul Petillo is the Managing Editor of BlueCollarDollar.com

Mutual Funds: Some Terms, Some TIPS, Some Bond Funds

Let's take a moment and clarify a few terms. Lately, investors and non-investors have heard some terminology being batted around, much of which all sounds the same. Inflation, deflation, hyperinflation, disinflation, stagflation. What do they mean and how do they ultimately effect your investments? Are TIPS the answer? Are bond funds protected?

We are all familiar with inflation. The term simply means that as long as your dollar stays in your pocket (or in the cookie jar or stuffed under the mattress) it is losing value. Often expressed as a percentage, it relates to the buying power of your money. In other words, if inflation is at 3% (for example) your dollar is actually worth less and when you eventually do decide to spend it, you will have to pony up an additional three cents to cover the costs.

Deflation is the opposite of inflation and much more troublesome. To be in deflationary environment is to see prices falling because there is no spending. Unemployment might be the cause. Tight credit might be the cause. Lack of government spending might also contribute. It has a spiraling downward effect that can be hard to change. Once folks stop spending, stop borrowing and basically hunker down, businesses react by layoff workers and producing less. Incomes shrink and the economy tanks. The Federal Reserve usually steps in making money available to borrow and increasing the supply of money available. Sometimes this is all that is needed; sometimes, as in the case of Japan in the nineties and through to 2006, it does not.

Disinflation is not to be confused with deflation. It is actually a good thing in many instances and can signal a reduction in inflation rates, which has the net effect of increasing the worth of the dollar in your pocket.

Hyperinflation is basically runaway inflation. The economy is out of balance. The country's currency has no real value and the balance between supply and demand is thrown out-of-whack.

Stagflation occurs when prices rise as manufacturers attempt to continue to profit but the job's market doesn't improve with those price increases. High prices and unemployment make for an unsavory pair and the result fo this often triggers inflation as well. When oil prices rise for instance but the economy has not provided enough jobs to absorb the increases, stagflation is often cited as the problem.

In tough economic times and with scary terms like the aforementioned get tossed around, investors look for some safety. Treasury Inflation Protected Securities are often where folks turn to cover their assets.

TIPS protect your principal and pay you a dividend (or coupon) every six months. That coupon is adjusted for inflation based on the Consumer Price Index or CPI. This is a survey of goods and their costs used to determine how much these items impact the average income.

And although this sounds like a good way to protect your money, the best way to do it is to buy those TIPS individually and not through a bond fund or ETF. Prices on these types of securities do change and you may lose money when you buy them in a fund.

Mutual funds will try to find bonds in which to invest. And while this is better achieved through a fund - they get better prices and are able to spread the risk among varying maturities - buying TIPS this way is not one of them.