Investors favor bonds in trying to cut risks

NEW YORK — Small investors, still jittery even as stocks roared back to life from the financial crisis, are turning back to the market looking for less-risky ways to reboot their portfolios.

Many mom-and-pop investors who dumped stocks throughout the downturn have remained wary, content to sit on the sidelines as the Standard & Poor's 500-stock index soared 65 percent from its lows in March to ring in the new year. But instead of buying back stocks, individual investors have increasingly poured their money into bonds, which are considered to be safer but could pose risks in 2010.

Investors in mutual funds, a popular way for small investors to access the markets, pulled roughly $250 billion from stock funds during the market downturn from October 2007 through March, according to the Investment Company Institute. During that 17-month period, managers of money-market funds saw a hefty $933 billion inflow as investors sought safety. Just about every investment was ravaged, including mortgage securities and stocks in emerging markets.

Although signs of an economic recovery began budding in spring, nine months later, retail investors have yet to jump back into stocks in full force, instead steadily putting money into bond funds in ever-larger sums.

With the damage to their retirement accounts still a recent memory, many small investors who have been sitting on their cash perceive investing in bond funds as "dipping your toe back in the pool," according to Rebecca Schreiber of Solid Ground Financial Planning in Silver Spring, Md. "I think this is how people are reintroducing themselves to the market."

There is also some chasing of past performance, analysts said, with investors pulling out of money-market funds earning near-zero interest to go after returns in bond funds, which returned an average of 13.5 percent for the year, according to Lipper, a data company that tracks mutual funds. Equity funds, meanwhile, gained an average of 34 percent.

But fund investors hoping for similar gains in 2010 will probably be disappointed, analysts say. High-yield bond funds, which invest in the debt of riskier companies with non-investment-grade ratings, were trading at average discounts of 50 to 60 cents on the dollar at their lows last year. They are now back up to trading in the 90 cents on the dollar and up, according to Ken Taubes, head of U.S. portfolio management at Pioneer Investments in Boston. High-yield bond funds returned a whopping 46 percent on average last year, according to Lipper. They are up nearly 4 percent over a two-year period.

"Returns will be greatly reduced from last year but still reasonable," said Taubes, who expects high-yield funds to return somewhere between the high single digits to the low teens for 2010.

Analysts also warn that bond investors may be in for a rude surprise when interest rates, which are at historical lows, eventually head back up. "Right now, interest rates are artificially low because the Federal Reserve has pumped so much money into markets," said Mark Coffelt, chief investment officer of Empiric Funds. "They're deliberately doing that to get the economy back on its feet. But at some point, they're going to have to get rates back up because they don't want inflation. I think there are going to be a lot of investors shocked at how fast those bond funds can go down when interest rates go back up."

Going forward, analysts say, investors should stay away from long-term bonds, which are more sensitive to rising interest rates, and stick to shorter-term issues.

Stock analysts also don't expect supercharged returns of 2009 to continue into 2010. Many investing pros are expecting stocks to return to more normalized gains of around 8 percent. After falling 57 percent from its October 2007 high, the S&P 500 soared 65 percent to finish 2009 with a gain of nearly 24 percent. The index was still off 29 percent from its record in October 2007 and finished down 24 percent for the decade. The Dow Jones industrial average of 30 blue-chip stocks ended up 19 percent for the year but down 9 percent for the decade. And the tech-heavy Nasdaq composite index closed up 44 percent for the year but down 44 percent for the decade.

"There's a sense of 'Now what?' People are still in shock," Fernandez said. "But the principles of modern investing still stay the same. An investor still needs to think about what their goals are and what their future plans are and have and hold a very diversified portfolio. It sounds like a broken record, but it's the only proven way that we know of that works to protect against situations like the one we just went though."