March 01, 2010
--- A new report from Morningstar warns those who flocked to bond funds in
2009 that even those investments aren't immune to volatility. ---
While mutual funds made up for some of the ground lost in 2008, taking in $377 billion in 2009, most of that recovery was thanks to bond funds, which accounted for $357 billion of the net inflows. Morningstar said fixed-income funds took in more flows in 2009 than they saw over the previous five calendar years combined.
Low yields in other income-producing investments, such as money-market accounts and bank CDs, likely pushed some investors into bond funds, and there was a bit of performance-chasing going on, as bonds held up better than most other asset classes in 2008. Most importantly, after experiencing harrowing losses in 2008, many investors reassessed their capacity for risk and increased their portfolios' allocations to lower-volatility asset classes, according to the report. However, Morningstar warns that bond funds aren't immune from volatility, and there are risks looming on the horizon that many new shareholders may not fully appreciate.
Sonya Morris, editorial director at Morningstar, noted that taxable bond funds accounted for most fixed-income flows in 2009, but on a historical basis, muni funds had a banner year, gathering an unprecedented $72 billion in assets, and blowing away the previous record of $21 billion in 2006. While demand will likely continue to work in favor of munis in 2010, at the same time, supply will be limited as the Build America Bonds program makes it more attractive for traditional muni issuers to gain financing via the taxable bond market. Those technical factors could support muni bonds in the coming months, according to the report.
On the other hand, state and municipal governments have seen tax revenues decline just as the demands on their resources are increasing. Credit-quality worries are rising to the surface after muni-bond insurance has faded to the background, Morris said. Fund managers told Morningstar they aren't expecting massive defaults, but downgrade risk is a real concern, and many have ramped up their credit-research efforts as a result.
"If credit-quality issues overshadow the positive technical backdrop, muni-fund shareholders could be in for some volatility over the near- to intermediate-term," according to Morris.