Americans' favorite investment has its work cut out for it this year.
Investors poured $389 billion into taxable bond funds last year. That's 63 percent more than their second-favorite fund category — international equity — and compares to a net inflow of just $12 billion to U.S. equity funds, according to Morningstar Direct data.
And despite a 50-basis-point (0.5 percent) rise in the 10-year Treasury bond yield — bad for bonds — the money keeps coming in.
"We still see good flows into intermediate-term and nontraditional bond funds so far this year," said Morningstar analyst Kenneth Oshodi. (Investors pulled more than $16 billion from high-yield bond funds in the first two months of this year.) "It's high-yield debt [fund flows] that have suffered most with the volatility."
For the first time in a very long time, it appears that interest rates are headed higher. Inflation remains below the Federal Reserve's target of 2 percent, but it is rising and there is growing expectation that it will soon become something more to fight than to hope for. The Fed seems convinced. Last month it raised rates a quarter point, to the range of 1.50 percent to 1.75 percent, and is telegraphing at least two more rate hikes this year.
While 10-year bond prices have recovered slightly from their fall early this year, most analysts expect the 10-year yield to continue moving higher and to finish the year above 3 percent.
"We think rates may finally march upward from here," said David Yeske, co-founder of investment advisory firm Yeske Buie.
That's bad for bonds and bad for bond funds — though not in exactly the same way.
The growing popularity of bond funds for investors is due to the simple fact that they are the simplest, cheapest way for investors to buy a diversified basket of bonds. Investors can buy the broad market of government and corporate bonds, they can target international fixed-income markets, or they can invest in slices of the market or sectors therein. Bond funds offer a degree of diversification that only large scale can bring.
"We think it's imperative to be diversified with bonds if you want more than just Treasurys," said Yeske. "Bond funds can give you a globally diversified portfolio at a low cost."
Yeske currently has his clients' bond allocations parked in funds with a duration of only one year, and he never stretches beyond three to five years' average duration. "Our view of the role of bonds is as a stable reserve of value," he said. "We're looking for low volatility."
Financial advisors, however, do have issues with the bond fund as an investment vehicle. Unlike individual bonds, funds do not have a maturity date. The pool of bonds mature at different times, and the net asset value of the fund reflects the value of all the securities holdings. The buyer of an individual bond simply can buy and hold it, and absent a default, receive their fixed interest payments and the return of their investment at maturity.
Bond funds hold no such guarantees. Income will vary depending on market conditions, and there is no promise that you'll receive your initial investment back when you sell. In an extended environment of rising rates and falling NAVs for bond funds, investors could suffer capital losses if they have to sell the investment.
"With funds, you don't own the bonds," said Jon Yankee, CEO of FJY Financial. "You own shares of a mutual fund. "There are thousands of decision-makers involved, and if they pull money from the fund, you can be affected negatively," he added.
Indeed, in times of major financial distress — see 2008 — a vicious cycle of redemptions and forced sales of bond holdings can cause huge losses, though usually at smaller, more narrowly focused funds.
Individual bonds won't protect you from rising interest rates either, of course. Even if an investor plans to hold a bond until maturity, its market price will drop if rates rise. If the position has to be sold earlier than expected, investors will take a loss.
The construction of a ladder of bonds that mature at different dates is an option that can help protect against rising interest rates. If income is needed from the portfolio, investors use the proceeds from a maturing bond. If not, it's reinvested in a new bond.
Unless the ladder is constructed with only Treasury bonds, the cost is likely prohibitive for all but the wealthiest investors.
"The smaller the purchaser, the more costly it is to get fixed-income exposure," said Yankee. Bid/ask spreads in the municipal bond market, for example, can be more than 1 percent higher for small investors than institutional buyers.
Unlike the stock market, transaction costs in the bond markets are very high, depending on the broker you purchase them from. With yields as low as they are now, the costs of building a bond portfolio can consume much of the income generated.
"No individual investor I work with has the scale of the bond fund manager we work with," said Yeske at Yeske Buie. He suggests that investors who need to sell portions of their bond holdings for income can do it more efficiently by investing in multiple bond funds of staggered duration.
"Depending on the rate environment, you liquidate the one that has been hit the least by rising rates," Yeske said.
He also argued that bond funds are not a trap in a rising rate environment. While their bond holdings can fall in value as rates rise, they are constantly reinvesting the proceeds of maturing bonds into higher-yielding replacements. That means income generated from the fund increases more versus a static portfolio of bonds.
For the vast majority of Americans, bond funds are the only affordable way to get diversified exposure to fixed-income investments. The annual fees are higher than typical equity funds, but they are dropping, thanks to pressure from low-cost passively managed funds that track an index. The average cost for actively managed bond funds is 0.92 percent compared to 0.27 percent for passive funds.
"We have some misgivings about bond funds," said Yankee. He advises wealthier clients to invest in separately managed accounts with third-party managers that typically have a minimum investment threshold of $250,000 or $500,000. "But we're not going to eliminate one of the most important asset classes for smaller investors."
For better or worse, bond funds will remain popular with investors.
— By Andrew Osterland, special ot CNBC.com