Government bond funds losing their allure

Investors are getting nervous about lowyielding government bond funds.

Worldwide, investors took a net $1.1 billion from U.S. long-term government bond funds last week, says EPFR, the biggest weekly outflow since it started tracking flows in 2004. “It was kind of a sleepy category until last week,” says Brad Durham, co-founder of EPFR.

Sleepy, yet government bond funds have dazzled the past five years. And that has lured investors. Government bond funds gained an average 30% the past five years, vs. an average 10% gain for stock funds, Lipper says. Funds investing in U.S. Treasury securities soared an average 44% in the same period, Lipper says.

Bonds are IOUS that pay regular interest until they mature, then investors get their money back. But much of government bond funds’ returns are from price appreciation, not income. Of the 44% total return the past five years for Treasury funds, half was share-price gains, Lipper says. The reason: When interest rates on newly issued bonds fall, traders bid up the prices existing of bonds with higher rates.

But rates are already near historic lows. The bellwether 10-year Treasury note yields 2.22%, and the 30-year T-bond yields 3.34%. What could push bond yields higher? -The end of Operation Twist. The Federal Reserve’s program of buying long-term bonds to keep rates low should end in June. Without it, Treasury yields could rise, and prices fall.

-Inflation fears. Although the government’s main gauge of inflation, the consumer price index, has been relatively tame, investors worry that today’s rock-bottom interest rates could spur a bout of inflation.

Bond traders view inflation the same way Superman views Kryptonite: Inflation erodes the value of a bond’s fixed interest payments. When traders think inflation is in the air, they bid bond prices down and yields up.

Bonds have been in a bull market since 1981, when the 10-year Treasury yield peaked at 15.81%. The past five years, investors have poured roughly $21.1 billion into intermediate-term U.S. government funds and $4.1 trillion into general U.S. Treasury funds, Lipper says.

Is this the beginning of a rush for the doors? Minyi Chen, vice president of Trimtabs, which tracks the funds, isn’t convinced. “It’s the first time we’ve had an outflow for a while, but it’s a really small outflow,” Chen says.