Will Bond Funds Be the Best Investment For 2011?

Investors who bet that bond funds would be the best investment for 2010 were not disappointed with their investment choice. Since smart investors look down the road six months or more that begs the question: will bond funds be the best investment for 2011 and what are the risks?

Just a glance at average annual rates of return for the 3-year period ending in mid 2010 helps explain the popularity of bond funds. Money market funds paid between 1% and 2% a year on average paying virtually nothing for the last 12 months. Stock funds had a wild ride with many of them LOSING 10% a year or more. Many high-quality BOND funds returned over 6% a year. Under one possible scenario these INCOME funds could be the best investment for 2011, or at least the best mutual funds. But don't overlook the risk factor.

Bonds offer a fixed yearly income based on a fixed interest rate that never changes for the life of the investment. When you own shares in a bond fund you own a small part of a large portfolio of these income producing securities, which trade in the open market like stocks do. Your total return from bond funds includes both interest income and gains or losses in the value of the securities in the portfolio. Hence, risk is a factor.

Bond funds are also referred to as income funds because that's their major attraction... higher interest income than you can get from other popular investment options or other mutual funds. They have been good investments in recent times and the best investment for 2010 for investors in search of higher returns without high risk. There are two basic reasons for this. Interest rates have been falling and inflation has been tame. Falling interest rates make the fixed interest income from existing or older bonds more attractive than that of new issues coming to market. Investors bid the price (value) of bonds up in the market because they are willing to pay more for the higher income.

Lower inflation makes a bond's fixed income payment more attractive, as the future buying power it represents will not be significantly diluted by a higher cost of living. Negative inflation is referred to as DEFLATION, where the cost of goods and services actually declines. If interest rates continue to fall and inflation follows suit and/or goes negative, bond funds are a candidate for the best investment for 2011. Some economists and professional money managers believe that this scenario could definitely happen.

On the other hand, interest rates are presently near historical lows due at least in part to the government's efforts to keep rates low to stimulate a lackluster economy. The question is whether or not the powers that be and/or the markets will push interest rates up in 2011? When rates go up inflation generally does as well and this is a formula for losing money in fixed income investments like bond funds. Higher interest rates and inflation make the fixed income from their securities less attractive; and investors in the bond market send bond prices down by selling.

Income funds have been some of the best mutual funds over the past 10 years and three years when things have been dicey for stocks and stock funds. Don't assume that this trend will continue. Watch the economic and business news. If interest rates continue to creep downward and inflation stays low or turns negative (deflation), bond funds could be your best investment for 2011 and beyond. If the opposite occurs it's time to lighten up on, or avoid bond funds altogether.

A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.

Jim is the author of a complete investor guide, Invest Informed, designed for average investors or would-be investors of all levels of financial background and experience. To learn more about investments and investing and his new financial guide go to http://www.investinformed.com.