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Investors Skittish on Bond Mutual Funds

July 31, 2003

NEW YORK (AP) _ As bond prices extend their declines, investors are more skittish about bond mutual funds and are clearly worried that bonds’ long rally has run its course.

Investors pulled $666 million out of taxable bond funds in the week ended July 23, the largest weekly outflow so far this year, according to AMG Data Services. That outflow was due mostly to funds that invest in mortgage-backed securities and investment-grade corporate bond funds.

Meanwhile, inflows into stock mutual funds totaled $3.2 billion, AMG said.

There’s been talk on Wall Street of the bond bubble that has burst, similar to that of the late 1990s bubble in tech and Internet stocks. But Micah Green, president of the Bond Market Association, says the two situations can’t be compared.

``When I think of the Internet bubble, particularly the Internet stocks I had ... when the bubble burst, I had nothing left. The value was in the inflated stock price and when they burst, there was nothing there,″ Green said. ``Bonds are very different.″

Green was talking about how bonds work. Bonds are considered safer than stocks, because they are essentially IOUs issued by a government or a corporation. Investors purchase bonds on the premise they will recover their investments along with some interest by the specified maturity date.

``If you bought bonds over the last few years, the value has gone up, up, up, until a few weeks ago. ... Does that mean there is nothing left? No,″ Green said. ``A bond is a loan that pays interest. ... Regardless of what happens to interest rates that doesn’t change.″

It’s not surprising that bond experts urge investors to stick with their bonds. However, investment experts in general also would agree, recommending investors have a diverse portfolio including stocks and bonds. While stocks are the best bet for increasing the cash in your portfolio, bonds are used to preserve it.

``There’s always a place for bonds,″ said Sharon Stark, chief fixed income strategist at Legg Mason. ``At some point you want some assurance that you (will) get some money back, at least what you put in.″

As far as returns on bond mutual funds go, it’s not clear that the bond buying binge should be over. While bond funds on average are down 1.3 percent so far in July, they still have a positive year-to-date return of 1 percent, according to fund tracker Lipper Inc.

And, bond funds have provided decent returns over the long term. On average, bond funds have a cumulative three-year return of 7.1 percent and a cumulative five-year return of 5.8 percent, according to Lipper.

One big reason why bond prices have declined and outflows from bond funds increased has to do with the economy and investors’ expectations that it rebounding. Earlier this month, Federal Reserve Chairman Alan Greenspan said in congressional testimony the economy is poised for strong growth in the second half of the year, raising questions about whether interest rates are headed higher to follow suit.

Greenspan’s bias toward lower interest rates _ 13 times since early 2001 _ to stimulate the economy was a boon to bonds and helped the bond market outperform the bear stock market.

Bond prices are linked to interest rates, both those set by the Fed and those that rise and fall within the bond market itself. Prices and bond yields move in opposite directions. The yield on the long-term Treasury bond is still close to multidecade lows but the concerns about rising interest rates have pushed yields higher.

Another reason why bond prices have fallen has to do with a more natural pullback by investors, who bid up bonds earlier this year amid fears about the war in Iraq and the strength of the economic recovery.

``There was so much uncertainty in the world that everyone fled to the safety of bonds,″ Stark said.

Still, Stark conceded that bonds’ recent heyday could be over. What that means, she said, is investors might want to ``peel back″ their bond exposure. She recommends investors at or near retirement have 60 percent of their investment portfolio dedicated to bonds and the remaining 40 percent in stocks.

For those who are still work and have several years until retirement, Stark advised having between 25 percent and 40 percent invested in bonds.

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