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Investors rethinking bond funds

By Sheyna Steiner · Bankrate.com
Friday, December 24, 2010
Posted: 8 am ET

Bond mutual fund investors may be warming to the possibility of an improving economy. Last week funds saw the largest withdrawals in two years, Bloomberg.com reported on Wednesday.

According to Investment Company Institute, or ICI, statistics, investors pulled $8.62 billion out of bond mutual funds the week of Dec. 15.

Institutional investors may have been mostly responsible for the large fund outflows and could be locking in rates by buying individual bonds, a consultant speculated in the Bloomberg.com story, "Bond investors take $8.62 billion out of funds in week, most in two years"

"I would guess most retail investors are staying put because you aren't seeing the money go anywhere else," consultant Geoff Bobroff is quoted as saying.

Investors have been piling into fixed income investments for the past two years. ICI research shows that total bond fund inflows totaled $642.8 billion between Jan. 1, 2009, and Oct. 31, 2010.

Why are institutional investors getting nervous?

If the economy continues to improve, as we're all hoping it does, inflation will also heat up. As a result, we'll see interest rates edging up.

Rising interest rates mean rising bond yields. Yields move opposite of price so investors may see the value of their investments drop. For investors holding individual bonds to maturity, that's not too much of an issue. For bond fund investors a decline in value will be unavoidable, particularly in long-term bond funds.

Although there is scant inflation now as measured by the Consumer Price Index -- the annual rate of inflation was 1.1 percent in November -- the market may believe the possibility is on the horizon.

Yields on the 10-year Treasury have climbed over the 3 percent threshold in December. On Wednesday the 10-year Treasury yield was 3.36 percent according to the U.S. Department of the Treasury.

From mid-July of this year until the beginning of December, the 10-year Treasury yield didn't break 3 percent and went as low as 2.41 percent in October.

It looks like next year promises to be interesting. Until then, enjoy the holidays.

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