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Bond funds popular, but not without some risks

The long romance with cash is over. Investors who once found bliss with certificates of deposit and money-market mutual funds are looking elsewhere for happiness. Increasingly, the object of their affections is a bond mutual fund.

Mutual funds that invest in bonds picked up $6-billion in new money in April _ their best month in four years _ and many fund companies say sales were even stronger in May.

But the sudden influx has some fund officials worried that not all their eager new shareholders understand the risks that bond investing entails.

"People should be aware that the net asset value (of fund shares) will drop when interest rates start back up," said John Woerth, a spokesman for the Vanguard Group of mutual funds in Valley Forge, Pa.

The basic problem for yield-hungry investors is that short-term cash investments just do not pay what they used to. The average yield on money funds is now 5.5 percent, down from 7.7 percent a year ago. A six-month CD that paid 7.8 percent a year ago is now 5.8 percent.

"A lot of people have gotten accustomed to a particular level of income, and when short rates come down like this, they're hurt," said William Rice, spokesman for Boston-based Colonial Investment Services, a mutual fund sponsor.

Rates on long-term debt investments also have come down, but not nearly as much, which means the gap is bigger between the reward offered by short-term and long-term investments. In economic lingo, the yield curve has steepened.

The result is a big increase in the appeal of government bond funds yielding between 8 percent and 9 percent, and corporate bond funds paying even more. Funds that buy tax-exempt municipal bonds also have been popular.

The strength of investor attraction for bonds shows up in the monthly investor surveys the University of Michigan conducts for Fidelity Investments of Boston. The percentage of investors planning to buy bond funds rose from 15 percent in March, to 23 percent in April, to 29 percent in May.

"Some of it (money going into bond funds) is coming out of our own money-market funds, but a lot of it, we suspect, is coming from the banking industry," said Charles Vieth, vice president of the T. Rowe Price funds in Baltimore.

Like CDs and money funds, bond funds pay regular income, but they also have special risks, including the potential for capital gains and losses. Share values of bond funds rise and fall in an inverse relationship with interest rates. In addition, many bonds carry the risk of issuer default _ a particular concern with high-yield corporate and municipal bond funds.

At Vanguard, the most popular bond fund of late has been one that buys securities backed by mortgages guaranteed by the Government National Mortgage Association _ known as Ginnie Maes. The fund currently yields an attractive 8.6 percent. However, Ginnie Maes have their own special risk _ if falling interest rates prompted large numbers of homeowners to refinance, both yields and share values could fall.

"Some people might just be searching for yield and not aware of the downside," Woerth said. "We think it's a good idea to make people aware of the risk."