Last fall I posted Bond Funds – Safe Haven or Risky Asset? The post was prompted by the massive influx of dollars into bond mutual funds. This trend continued through the end of 2009 when inflows into bond mutual funds reached a record $396 billion.

This was likely prompted by several factors:

Low yields on money market funds

Bonds outperformed stocks for the decade just ended

Tremendous returns for bond funds in 2009, the average bond fund gained 17% with many posting far better results

Bond funds can be volatile, however, as we learned in 2008. The management team running Loomis Sayles Bond Fund was selected as Morningstar’s Fixed Income Manger of the Year for 2009. The institutional share class of the fund gained over 37% in 2009, an astounding return for a bond fund and almost 8% above the average muti-sector bond fund in the Morningstar universe.

Going back a year, the fund lost almost 22% in 2008, an equally astounding loss for a bond fund.

The losses in 2008 for Loomis Sayles and most other investment grade bond funds were due to an aversion to anything carrying more risk than a Treasury in the last quarter of 2008. Credit worthiness and low interest rates didn’t matter. Nobody wanted to take ANY credit risk.

The appetite for risk and a stretch for yield returned in 2009. Stung by the performance of their stock investments in 2008 many investors turned to bond funds in the hope of better than cash yields with lower risks than stocks.

Bond funds face risks going forward from two sources:

Rising interest rates – With rates at historic low levels, mounting levels of government debt to finance, and the normal rise in interest rates that comes with an economic recovery there will pressure on interest rates to rise over the next few years. Rising interest rates, all else being equal, result in lower prices for existing bonds and bond funds.

The prospect of inflation - Many think inflation will return as the economy heats up and the full impact of the government’s stimulus programs ripple through our economy. Inflation is the enemy of bond investors because of the fixed nature of bond interest payments. In a period of rising inflation, these fixed payments lose purchasing power to inflation over time.

I am not advocating that investors avoid bond funds or sell off their existing bond fund holdings. Rather, I want to point out the potential risks ahead for bond funds. The year just ended was a year of recovery and relatively easy gains for bond fund investors. The coming years may well not provide opportunities like 2009.

Photo by: Alan Cleaver