Bond funds: a safe haven no longer

After getting tossed around by stock mutual funds the past few years, investors might have thought they had found a safe harbor in bond mutual funds.

Ouch! Instead of safety, they bumped into rising interest rates. Since bonds - and the funds that invest in them - are tied to interest rates, many bond funds faltered in the third quarter.

Overall, fund-tracking company Lipper calculates domestic long-term fixed-income funds averaged a mere 0.4 percent gain during the three-month period that ended Sept. 30. They're still up 6.1 percent this year, and 8.8 percent for the past 52 weeks, but the notion that they're free of risk was squashed for many investors.

Indeed, long-term bonds seemed to bear the brunt of the attack. This is money invested for perhaps 10 years or more, which is especially susceptible to a retreat when short-term rates rise. Long-term US government bond funds gave up 2.46 percent of their value during the quarter, according to Emily Hall of fund-tracking company Morningstar. And it didn't help that the interest that they pay out has also been pretty lackluster, she says.

But not every bond fund behaves the same way. So it pays to be choosy, says Paul Merriman, of Merriman Capital Management based in Seattle.

During the quarter just ended, "high-yield actually made money," Mr. Merriman says of junk-bond performance. And long-term bonds lost ground. Merriman says he saw one fund, which trades in zero-coupon bonds, shed 14 percent of its value. "It's obvious, [performance] is all over the place."

Most people buy bond funds because they want either the steady income or the stability that many stock funds lack. But those two goals can conflict. A long-term bond that pays a good rate of return could be very volatile in the wrong market. Merriman advises against long-term bonds for the time being. "We advocate short-term bonds," he says. "If you want stability, you don't want long-term bonds in your portfolio, ever."

Mutual funds are an easy way to get into bonds, Merriman points out. Buying individual bonds of differing maturities and interest rates can be prohibitively expensive, and getting out of an individual bond before maturity can be tricky, too.

Going forward, bond-fund investors may get some breathing room since interest rates have stabilized somewhat, says Brian White, manager of mutual fund marketing department at New Jersey brokerage house Ryan & Beck.

Still, good things don't last forever, says Ms. Hall of Morningstar. Third-quarter performance offers a strong signal that "the long-awaited end to the bond-market rally has started," she says.