Every time the stock market turns nasty, investors grab for their security blanket.
That would be bond funds. Check out mutual fund industry sales figures in the months following a stock market plunge and you'll typically see bond funds surging while equity funds hemorrhage money.
"I think it's driven by uncertainty and anxiety," said Norman Raschkowan, executive vice-president and North American investment strategist at Mackenzie Financial. "People think they should be saving and putting money into their RRSP, but given their experience in the stock market over the past few years, they're parking money in bonds."
Bond funds have been a rock for investors since the global financial crisis began in 2008, and last year they averaged a gain of 6.8 per cent. But is that a solid rationale for the heavy buying of bond funds we saw late last year, as the stock markets weakened?
Hank Cunningham, a 40-year veteran in the bond market and author of In Your Best Interest: The Ultimate Guide to the Canadian Bond Market, said the answer is no. In his mind, people are making the classic mistake of performance-chasing, or buying into an investment category only after it has surged in price.
"It's like, my neighbour has done well in bonds, so I better get some," said Mr. Cunningham, who is also fixed-income strategist at investment dealer Odlum Brown. "But I think the horse has left the barn on this one."
We saw a vintage buying spree in bond funds in December, as Canada's stock market was putting the finishing touches on an 11-per-cent decline for the year. The fund companies that are members of the Investment Funds Institute of Canada reported net bond fund sales of $1.5-billion (that's new sales minus redemptions). Net sales for balanced funds (a mix of stocks and bonds) amounted to $1-billion, while there were net equity fund redemptions of $1.5-billion.
Those sales figures are understandable in the context of last year's investing environment. The stock markets started well, then tanked. Bonds offered a refuge from stocks, and then also benefited from a decline in interest rates as the global economy sagged. Bonds increase in price when rates fall, and they lose value when rates rise. So if you owned a bond fund in 2011, you benefited from both interest payments and rising bond prices.
This year is unlikely to offer much in the way of falling interest rates that push up bond prices. Rates could edge a bit lower if the global economy lapses into recession, but there's just not a lot more room on the downside. Of course, it's also possible that rates might rise a little this year or next.
Bond funds could give people zero returns or lose money if rates rise, Mr. Raschkowan said. "People don't appreciate the capital risk they take with bond funds. They often assume bonds are like Canada Savings Bonds and GICs. But if interest rates move up, there will be a downward adjustment in price."
Regardless of whether rates make a small move up or down this year, bond funds will be weighed down as they always are by high fees. Here are the basic economics of bond funds: Average management expense ratio of 1.72 per cent. Yield on five- and 10-year Government of Canada bonds: 1.3 and 2 per cent, respectively. Provincial and corporate bonds will get you slightly higher yields, but nothing dramatic.
For investors with small accounts, low-cost bond mutual funds and bond exchange-traded funds are the best way to squeeze acceptable returns out of bonds in today's market conditions. Those with larger accounts should consider using individual bonds, including those issued by governments and financially strong corporations.
And don't overlook guaranteed investment certificates from alternative banks, trust companies and credit unions covered by deposit insurance. You can't sell them as easily as a bond or bond fund before maturity, but the yields should easily beat quality government and corporate bonds.
For tips, stories, videos and live chats ahead of this year's RRSP contribution deadline, check the Globe Investor 2012 RRSP season section for daily updates.