Are Bond Funds Still Attractive?

During the 1990's bull market, many dismissed bonds as plodding investment vehicles that only produced single-digit returns. But when hotshot stocks sputtered, those pedestrian bonds pressed forward. Today, the value of a fixed-income allocation is painfully obvious: During the past two years, long-term government funds have returned 10.5 percent annually, compared with a 21 percent decline in the

During the 1990's bull market, many dismissed bonds as plodding investment vehicles that only produced single-digit returns. But when hotshot stocks sputtered, those pedestrian bonds pressed forward. Today, the value of a fixed-income allocation is painfully obvious: During the past two years, long-term government funds have returned 10.5 percent annually, compared with a 21 percent decline in the S&P 500. For the past 10 years, long government funds returned 7.8 percent annually, half a percentage point ahead of large-growth stock funds.

Advisors who are kicking the tires of bond funds these days, however, might be entering the market too late. Yields on 10-year Treasury bonds recently settled near 40-year lows. While rates could go lower, chances are the pendulum will swing up to some degree over the next year — and when rates rise, bond funds fall. In 1999, the last year when rates climbed significantly, long government funds lost 6 percent. To appreciate the current risk, consider that intermediate-term rates dropped a percentage point from June 2002 to November 2002; rates could easily retrace their path in the near term and rise 1 percentage point. For an idea of how a typical bond fund would weather such a setback, study its duration, an indicator of sensitivity to moves in rates. With a duration of 10.3 years, Vanguard Long-Term U.S. Treasury, for example, could lose more than 10 percentage points in a 1-percentage-point rate rise; PIMCO Total Return, which recently overtook Vanguard 500 Index to rank as the mutual fund with the most assets, could be in line for a loss of roughly 4.5 percent.

What should advisors do with their clients' money? With stock markets erratic, wary clients may prefer to maintain a large fixed income allocation. One approach is to take shelter in money markets, which almost never suffer principal losses. But taxable money funds recently yielded a piddling 0.96 percent, according to iMoneyNet. A preferable alternative might be short-term bond funds. Many of these yield more than 4 percent and focus on securities with maturities of three years or less. While rising rates weaken short-term bonds, the damage is usually limited and short-lived. During the past decade, short-term funds have never come close to recording a losing year. Even in 1999, with a head wind from rising rates, short-term bond funds still eked out a 2.3 percent return. “Short-term [fund] share prices rarely fluctuate very much,” says Morningstar analyst Scott Berry.

In this group, the safest members are the ultrashort funds, which focus on securities with maturities of six to 12 months. Their aim is to outperform money markets while taking on only a bit more risk. A top choice is PIMCO Short-Term A, which currently yields 3 percent. Portfolio manager Paul McCulley seeks to beat money markets by about one percentage point annually. McCulley admits that his fund could trail money markets for a few months during a period of climbing rates. But the fund adjusts quickly to rising rates. As PIMCO's short-term securities mature, they are replaced by new issues with higher yields. “If you are holding cash that will be needed to pay grocery bills in the next six months, then you should use a money-market fund,” says McCulley. “But if your time horizon is longer than six or 12 months, you can feel safe using our fund to obtain extra yield.”

Bond funds that shouldn't collapse any time soon
Fund Ticker one-year return three-year return five-year return expense ratio
American Century Short-Term Government TWUSX 4.0% 6.6% 5.6% 0.59%
AMF Adjustable Rate Mortgage ASARX 3.1 5.6 5.3 0.49
Franklin Adjustable U.S. Government FISAX 3.5 5.6 5.1 0.95
Oppenheimer Senior Floating Rate A* N/A 1.5 3.0 NA 0.87
PIMCO Short-Term A PSHAX 1.6 4.7 4.9 0.85
Source: Morningstar. Returns through 10/31/02.
*closed-end fund

While PIMCO typically has an average credit quality of AA, the fund often boosts yields by holding some corporate issues rated BBB, the lowest class of investment-grade bonds. When McCulley fears that interest rates are about to rise, he buys securities with very short maturities, taking the fund's duration down to 0.5 years or lower, a risk level approaching that of a money market.

Those willing to take on a hair more risk in return for slightly higher yields can try short-term government funds. These funds hold a mix of Treasurys, bonds from agencies such as Fannie Mae and mortgages that are guaranteed by agencies. In recent months, funds focused solely on Treasurys outperformed broad-based government funds, as investors fled to the safety of Uncle Sam's debt. But when interest rates rise, broader government funds should win. Mortgages yield a percentage point or so more than Treasurys, which will help prop up government funds in a difficult market. A solid choice is American Century Short-Term Government, which yields about 3.5 percent and has outperformed PIMCO's ultrashort fund by about half a percentage point annually during the past five years. American Century's portfolio manager, Michael Shearer, runs a conservative ship, keeping a third of assets in Treasurys and the rest in high-quality agencies and mortgages. “There would have to be a huge spike up in rates for us to report a negative total return in the next year,” Shearer says.

Another way to hold down risk is by owning adjustable funds, which invest in pools of adjustable-rate mortgages. As rates rise, so do monthly payments from homeowners. That boosts yields for adjustable funds. In contrast, conventional bonds pay a fixed stream of income that becomes less valuable during times of rising rates. “We're likely to see mortgage rates rising soon, and adjustable funds should do relatively well in that environment,” says Raymond J. Lucia, a registered investment adviser in San Diego.

Franklin Adjustable U. S. Government Securities ranks as a steady member of this group. The fund owns only securities that are rated AAA because they are guaranteed by agencies. Another solid choice is AMF Adjustable Rate Mortgage. AMF has delivered solid returns during periods when rates were rising and when they were falling.

Investors seeking to profit from rising rates should consider prime rate funds, which invest in loans made by banks to corporate borrowers. Because interest payments on loans reset every 30 days or so, yields can climb steadily during times of rising rates. In addition, the share prices of the funds can climb as rates rise and the economy strengthens. This occurs because the bank loans are made to below-investment-grade clients. As the risks of default decline, the loans become more valuable, and their prices can climb. A top performer is Oppenheimer Senior Floating Rate A, which currently yields 4.25 percent. Portfolio manager Art Zimmer runs a diversified portfolio, holding a broad selection of loans from a variety of industries. “To limit default risk, we usually have less than 1 percent of assets in any one loan,” he says.

Keeping a close eye on risk, prime rate and other safe funds can provide important cushioning for any portfolio. In a time of uncertainty, these short-term holdings can help ensure that clients achieve their long-term goals.

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