One of the recurring themes with mutual funds investing is the topic of investment management (it has been stressed throughout these posts). And this, naturally, is where bond funds slip onto the scene. As with every good investment management strategy, bond funds fill the all-important but often overlooked fixed-income pocket of your portfolio. But not all bond funds are created equally. In fact, unlike straightforward equity funds where an equity is an equity is an equity, your bond funds will involve different types of fixed income assets, each of which can have different sensitivities to the same market impulses.

In periods of low interest rates, bonds funds are usually a place to avoid. The reason for this is simply because rates and bond prices have an inverse relationship. In other words, when rates start to rise, bond prices start to drop. However, even in periods of low interest rates, there are opportunities in bonds and bond funds, but the decision as to where to invest (e.g. long-term, short-term, muni, corporate, junk, etc., etc., etc..) is much more complicated.

In periods of elevated interest rates, bonds become more attractive because along with the higher income, the potential for falling rates enables the investor to enjoy capital gains in the price of the underlying bonds. The problem when it comes to bond funds is determining whether the fund manager bought too low, whether the fund manager has cash sitting in the bank that will allow for additional purchases at these elevated rates, whether the manager will have to offload bonds at a loss and so on.

In some ways, investing in bonds individually can sometimes be easier than investing in a bond fund where the investor buys the whole package rather than being able to cherry-pick the winners and ignoring the losers.

Why This Time It Really Is Different

There are many reasons why the search for properly performing bond funds is different this time around. Much of it has to do with what caused the economic collapse in the first place; credit and risk underwriting. This resulted in credit-granters withholding funds in an effort to stem potential losses. This is normal. A child who burns himself on the stove will not want to cook until he realizes what he can do to avoid getting burnt again.

However, even the most risk-averse credit granters realized that some companies seeking credit actually were still credit-worthy. However, to offset the risks associated with lending money, rates increased substantially while rates that governments were paying were on the way down. This is what is meant by the “spread” between corporate and government bonds. Where that spread is normally more narrow, those spreads were rather wide over the past two years. They are currently in the process of narrowing.

The narrowing of the spreads involves two event.

The first is that corporate bond rates drop. This is good news for the higher-rate bond holders as their bond values will increase and their income will remain constant.

The second event is government bond rates start to increase. This is bad news for the bond holders because not only is income low, but those prices will start to drop as well.

Where the unlucky investor stands to lose is in buying the wrong bond fund. While it may seem safe and cozy to invest in government bonds as the risk is lower than corporate bonds, the true risk lies in the fact that government rates will start to increase. This puts downward pressure on the price of those bonds, causing the investor to realize a capital loss.

The better decision would be to invest in bond funds that are corporate in nature; high yield investments. This makes better sense, especially as the risks involved with these bonds and companies disappear and the rates start to drop. This could take well over one year or more to happen, making high yield investments ideal for 2010. (See High Yield Investments: Top Pick for 2010 post for our choice for this year). However, an active investor might way to trade out of such bond funds as government rates become inflated and switch to government bond funds.

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