Why bond funds are suddenly hot

By Mina Kimes, writerApril 12, 2010: 11:01 AM ET

(Fortune) -- Mutual fund companies, just like individual investors, are prone to following the herd. So it's not surprising that, since bond funds attracted nearly $400 billion in 2009--versus a net $9 billion outflow of capital in stock funds--new bond funds are springing up to absorb the surging demand. So far this year, 16 fixed-income funds have launched, according to investment research firm Morningstar, compared to 14 new stock products.

That difference sounds tiny, but it marks a notable swing from 2009, when asset management firms rolled out 179 stock funds and just 72 bond products. To understand how dramatic the change in investment strategy has become, consider this: launches of domestic stock funds outpaced taxable bond funds by more than two to one last year.

Now that bonds are the asset du jour, though, money managers are all too happy to jump on the trend, says mutual fund consultant Geoff Bobroff. "The addition of bond funds is a lagging indicator," he says. "It's following the market." Morningstar analyst Eric Jacobson agrees. "Across the asset management industry, companies that didn't have highly developed bond resources are thinking, we need that," he says. "Even if we have it, we need to be in that space more."

Several of the new funds come from companies that are hardly dilettantes in the bond world. DoubleLine Capital, a fixed income shop headed by former TCW star Jeffrey Gundlach, just launched DoubleLine Total Return, which focuses on mortgage-backed securities, and DoubleLine Emerging Markets Fixed Income. BlackRock (BLK, Fortune 500) also rolled out a new fund, BlackRock Fund Multi Sector Bond, which will be helmed by Curtis Arledge, the CIO of fundamental fixed income.

The big question is why are bonds suddenly sexy? Blockbuster returns aren't an answer. Bonds dramatically underperformed stocks last year. In 2009, the S&P 500 returned 27%, crushing the Barclays U.S. Aggregate Index's 6% return.

The allure has more to do with psychology than profit-seeking. The retail-investing crowd, says Jacobson, is still reeling from the beating that stocks took in 2008. "In the wake of the financial crisis, people are more conscious of the role of bonds in their portfolios," he says.

Institutions, too, are rethinking their exposure to stocks after enduring two bear markets in a single decade, says Arledge. "Investors had large asset allocation to equities," he says. "Some were underinvested in fixed income."

The sea change in demographics also supports the shift to fixed income. Tim Bond (no bias), head of asset allocation at Barclays, wrote in a recent note that the price-to-earnings ratios of stocks are likely to shrink "due to dwindling support for equities, as the boomer generation ages into retirement."

Given the secular trend, it's easy to see why money management firms would invest in bond offerings--but it's less apparent that it's a good move for investors. In fact, market strategists have turned bearish on bonds in recent months due to concerns that the Fed will hike interest rates. When rates go up, lower yielding bonds look less attractive, bringing down their prices and cutting into fund returns.

While most economists think the Fed won't act for a while, fears of rising rates can push down bond prices ahead of any actual policy changes. That's part of the reason why Arledge's new fund will focus on shorter duration securities with lower interest rate risk, he says.

Meanwhile, once- and even still-hot stock selectors are trying to figure out why they're no longer popular. "Your straightforward equities manager is having a hard time gathering assets," Tjornehoj says. "Investors are just not beating down [their] doors looking for new products."