Investors trying to duck a blow from the stock market by moving to bonds may be positioning themselves to take a left jab that they didn't see coming.
As the economy has weakened lately, investors pulled about $3 billion from stock funds and poured more than $8 billion into bond funds - presumably for safekeeping. It's a continuation of a trend that began during the stock market crash, when nervous investors yanked about $200 billion from stock funds and added $340 billion to bond funds.
Yet, while investors may be trying to protect their money, they have been pouring cash into high-yield bonds, which are the riskiest and the most likely to plunge along with stocks if the economy takes a turn for the worse.
In addition, even some of the supposedly mild-mannered, diversified bond funds that investors buy for well-rounded, core exposure to bonds, may not be the carefree choices people envision. With safe U.S. Treasury bonds paying little interest, some fund managers have become more daring and added more high-yield and emerging-market bonds than usual to spice up returns for income-starved investors.
"This is part of the engineering of the Fed," said James Swanson, chief investment strategist for MFS Investments, who recently cut exposure to high-yield bonds as the economy's growth rate appeared to slow. "They are forcing people to take on more risk through preferred stock, junkier companies and foreign bonds. If there is a contraction in the economy, defaults could rise."
During the past two years, the average fund that invests in intermediate-term government bonds has provided investors just 4.17 percent a year, while the average high-yield bond fund has paid about 23 percent, according to Lipper. Those extraordinary gains have given investors a sense of security as they've sought solace from the painful stock losses of 2008 and early 2009. But those gains have the potential to cut the other way in a downturn - leaving losses people wouldn't expect from a faithful fund.
High-yield bonds come from companies with shaky finances, and amid economic weakness those firms can have trouble paying investors back. Besides high-yield risk, funds are investing more in foreign bonds and making bets on currencies that could turn out to either help or hurt investors. Gyrations in the value of the dollar and currencies are difficult to predict.
Until recently, few diversified bond funds would have made these bets, said bond analyst Eric Jacobson, of Morningstar. Pimco led the way and has expertise, but Jacobson said investors should make sure their funds have the "depth and breadth" to handle the complexity.
Losses in diversified bond funds, which hold an array of tame and risky bonds, are not common, but they do happen - especially when fund managers have taken on extra risks prior to a downturn in the economy. In 2008, investors witnessed a stunning example when the average bond fund lost 14 percent. High-yield bond funds lost 26 percent as the stock market dropped 38 percent.
"We saw how the movie ended the last time, and we don't want to go through that again," JPMorgan Fixed Income Portfolio Manager Jim Cavanaugh warned pension and endowment managers at a recent client event. Referring to 2008, he reminded investors that funds tried to lift returns then by buying mortgage-related bonds without appreciating the risks. Now, he said, too many popular funds - including those commonly held in 401(k) accounts, college funds and IRAs - have increased risky assets such as high-yield bonds and currency exposure to 20 percent of the portfolio.
Morningstar fund analyst Miriam Sjoblom has raised similar concerns. She recently noted that public filings show funds such as Janus Flexible Bond, Delaware Diversified Income and Loomis Sayles Core Plus Bond devoting close to 20 percent of their assets to high-yield corporate bonds in early 2011.
Meanwhile, she said, T. Rowe Price High Yield and Western Asset High Yield have trimmed their fund's exposure to some of the riskiest bonds, rated CCC. And Mark Notkin, of Fidelity Capital & Income, who tends to be comfortable with more lower-quality bonds than his peers, said he trimmed back lately.
Those cutting back are not predicting a recession. Rather, they simply note that high-yield bonds have been so popular that they no longer pay high yields to compensate investors for the risks they take.
If inflation and interest rates rise and investors can get higher yields in safe U.S. Treasury bonds they may sell high-yield bonds and pick Treasurys instead, undermining the value of the riskier bonds.
Craig Elder, a Baird Private Wealth Management fixed-income strategist, said that two years ago high-yield bonds were providing yields of 12 to 14 percent, which rewarded investor risk. But he is not interested in today's record-low 6.7 percent yields.
Rather than accept such a low yield for high risks, he said, he steers clients in the 35 percent tax bracket toward general-obligation municipal bonds. But investors who put money into high-yield bonds when they were yielding 12 percent do not have to bail from their investments, he said. The greatest risk is for people investing now and people devoting too much of their portfolio to risky investments.