Fundline: Bond funds take a dive

You might expect to lose 10% or more from a stock fund during a bad quarter. But a bond fund? Almost never — at least until this year.

Bond funds are the milquetoast choice among mutual fund investors: reliable plodders that give you a bit of income and relatively little volatility.

But some bond investors were unexpectedly slammed during the first three months of the year. RMK Select High Income, for example, plunged 22.4% in the first quarter (including reinvested dividends), according to Lipper.

You expect high-yield funds to be volatile. And the RMK fund is just a small fish in the big bond pool. Schwab YieldPlus, though, was aimed at more conservative investors. And it's a very big fish indeed; at least it was until the subprime mortgage meltdown. That fund plunged a shocking 19.9% in the first quarter.

What happened? These funds gave shareholders a taste of the pain that institutional investors suffered as the subprime mortgage market imploded.

The RMK fund invested in high-yield, low-quality bonds, which suffered badly during the subprime meltdown.

The Schwab fund had a huge 40.8% stake in mortgage-backed securities.

Both funds seem to be geared toward income-oriented investors who want a bit more yield than they might get from a money market fund.

Those investors enjoyed the higher yields — both funds now yield more than 7%, thanks to their big price declines — but they also absorbed far more risk than they might have bargained for.

Charbroiled emerging markets

How do you know when emerging-markets mutual funds are overheated? One clue: the emergence of funds that invest in progressively tinier countries. Right now, the indicator is registering somewhere between "charbroiled" and "toast."

Diversified emerging markets have certainly been hot: They soared a searing 36.8% in 2007, according to Morningstar. Such funds, in fact, haven't returned less than 23% in a calendar year since 2003.

Typically, as emerging markets overheat, investors begin looking for ever-tinier, ever-hotter markets to explore.

By the time funds begin touting the virtues of the Andorran market, the emerging-markets upswing has usually run its course and is teetering on collapse. Some ominous signs:

•T. Rowe Price launched its Africa & Middle East fund in September, focused on tiny emerging markets.

•Likewise, Fidelity plans to launch an Emerging Europe, Middle East and Africa fund, says FundAlarm.

•Merrill Lynch has created the Frontier Index, which tracks 17 tiny markets, ranging from Cypress to Kazakhstan, though there are no funds that track the index yet. And institutional money manager Harding Loevner has registered its own Frontier Emerging Markets Fund.

Not surprisingly, most emerging markets took a dive in March, according to MSCI Barra. Two of them — China and India — lost 23.7% and 27.1%, respectively, in the first quarter.

The frontier stock markets tanked as well. Romania and Slovenia both shed about 18%. And the Vietnamese market plummeted 44%. Can Andorra be far behind?

Briefly …

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