NEW YORK (Reuters) - Money is still pouring into U.S. bond mutual funds after last year’s record-setting $374.6 billion, a classic sign that the fixed-income market -- and the forlorn small investor -- is ripe for a bruising.

Burned by the equity market meltdown in 2008 and awarded record bond performance last year, when numerous funds posted double-digit returns, investors are staying the course and fail to see the rate trap that looms, some analysts say.

Many investors believe subdued inflation, held back by high unemployment and a gap between productivity and demand, will keep interest rates in check. U.S. consumer prices excluding food and energy fell in January for the first time since 1982.

But the once-in-a-lifetime performance of bonds in 2009 and unease over stocks has lulled investors to plow more money into fixed income in a misguided flight to perceived safety.

“These people, they’re investing in bonds because they wanted yield,” said Thomas Atteberry, a money manager at First Pacific Advisors Inc in Los Angeles. “The money market fund wasn’t giving them anything and so they went into corporate, government, mortgage, some high-yield, that whole gamut.”

High-yield "junk" bonds on average returned 41.15 percent in the 52 weeks ending February 18, according Lipper, a unit of Thomson Reuters Corp TRI.TO. But nearly all bonds performed well last year: corporate BBB-rated funds returned an annual 27.26 percent through last week, and general bond funds had returned an annual 14.2 percent, Lipper data show.

Investors pulled $536.7 billion from zero-interest paying money market funds last year, according to the Investment Company Institute. ICI data show a record amount of fresh money flowed to U.S. bond funds in 2009, more than double than any previous year.

That massive inflow continues in 2010.

"Our thesis is they probably don't understand the interest rate risk they took by doing that," said Atteberry, who manages the $3.9 billion FPA New Income Fund FPNIX.O.

Record investment flows are typical signs of market bottoms -- and peaks -- as the average investor is the last to show up for a bull market or become aware that sentiment is about to turn.

Investors added a record $309.4 billion to U.S. equity mutual funds in 2000 at the height of the tech bubble; the only outflows from stocks the past 20 years were in 2002, 2008 and 2009, years that marked deep troughs before sharp market rallies, ICI data show.

Steady consumer prices now mask a likely rise in bond rates due to rising inflation expectations -- when businesses and others try to anticipate higher prices -- and market demands for higher returns, some analyst said. If rates rise, it will crush the return of investors locked into low-yielding debt.

The benchmark U.S. Treasury note yield now trades at about 3.70 percent. A rise to its average yield over the past half century of about 6.2 percent could prove bumpy for markets and onerous for investors as prices, which move inversely to yield, drop.

Atteberry believes that the return on the 10-year U.S. Treasury note over the next five years will be about 90 basis points, or less than 1 percent. U.S. inflation may rise at a faster pace than economic growth, he said.

Short- and intermediate U.S. Treasury-based bond funds have returned less than 5 percent over the past year, but are a minor chunk of U.S. mutual fund assets.

Jane Caron, chief economic strategist at Dwight Asset Management Co in Burlington, Vermont, which oversees $68.8 billion in fixed-income assets, said she would not be surprised to see Treasuries deliver a negative return this year.

“It’s potentially a tough environment for bondholders looking ahead, given our trend in where the economy is probably going and our current fiscal and monetary positions. All this points to a very negative outlook for bond prices,” she said.

Caron said even if inflation and its trajectory remain subdued, interest rates are likely to rise because demand will lesson after the Federal Reserve stops buying debt in March.

“Even if inflation trends remain perfectly quiet this year, and there’s no reason to be concerned about inflation, I still think you’re going to see an increase in interest rates ... just for simple supply and demand reasons,” she said.

For investors who must be invested in bonds, keeping their maturity short or buying floating-rate securities, are the best protection against rising rates, said Carl Kaufman, in charge of fixed income strategy at Osterweis Capital Management in San Francisco.

“A lot of high-yield companies issued a lot of floating-rate paper. That’s one way you can play it,” Kaufman said. “The other way you can play it is to buy shorter-duration paper, which has been the mainstay of our strategy. I’m starting to buy shorter-paper now, just to get to ready.”

Equities, however, are a better inflation hedge than bonds, said Bill Hackney, chief investment officer at Atlanta Capital Management Co LLC in Atlanta, where he helps oversee $8.5 billion in assets.

Investing boils down to figuring out where inflation is going to crop up when all investment alternatives are considered, Hackney said. Natural resource stocks in emerging markets provide an inflation hedge, as does energy worldwide.

“You want to watch the energy stocks. You also want to watch those areas of the U.S. economy where we help the rest of the world deal with inflation, and that’s through technology,” Hackney said.