“Mutual-fund investors are still jumping on the bond bandwagon, one of the few pockets of positive returns this year. But bond-fund investors may face an increasingly bumpy road ahead,” writes Karen Damato in today’s Wall Street Journal.

“Fleeing the persistent bear market in stocks and low interest rates on bank savings, investors pumped $68.9 billion into bond funds in the first nine months of this year. That is five times the cash that went into stock funds, and it is a big change from 1999 and 2000, when stock-infatuated investors withdrew a total $54.1 billion from bond portfolios.”

“But pouring more money into bond funds as interest rates fall ever lower — the situation today following this week’s interest-rate cut by the Federal Reserve, its 10th this year — poses considerable risk and requires careful selection. And a new survey by American Century Investments suggests many individuals are ill-prepared for tackling the vagaries of fixed-income investing.”

” ‘People really don’t understand bonds,’ says Colleen Denzler, a vice president and senior portfolio manager at fund group American Century in Kansas City, Mo.”

“One of the bond basics about which many investors are clueless, for instance, is the fundamental seesaw relationship between interest rates and bond prices. Only 31% of 750 investors participating in the American Century telephone survey knew that when interest rates rise, bond prices generally fall.”

“Yet that inverse movement between interest rates and bond prices is a critical fact for bond-fund buyers to understand these days, when short-term interest rates are at their lowest levels in four decades. The interest rates on some types of bonds are likely to increase whenever the economy eventually rebounds from the current slump.”

“And in a period of rising rates, as bond prices fall, some types of bond funds may actually post negative returns. ‘It can happen, and it has happened,’ says Robert MacIntosh, chief economist and a bond-fund manager at Eaton Vance Management.”

“The fact that investors are snapping up bond funds only now, after sharp drops in interest rates, is evidence that ‘people don’t have a very good understanding of bonds and bond funds,’ says Ian MacKinnon, a managing director in the bond-fund area at Vanguard Group, Malvern, Pa.”