Bonds Not as Risk-Free as They May Appear
The modern investment world, like the world of the ancient Greeks, has its share of myths, one of which asserts that bonds and the mutual funds that invest in them aren’t very risky.
Actually, bond funds and other types of fixed-income securities can be quite perilous. In certain cases, they can be more volatile than stocks.
That might surprise some people. Many bond fund shareholders aren’t aware of, or choose to ignore, the downside potential of their portfolios.
Usually, however, the market won’t let them turn a blind eye forever. “You can tell people about risk, but until they feel it in their wallet, they might not recognize it,” says Robert Rodriguez, portfolio manager of the FPA New Income Fund in Los Angeles.
What’s needed is an understanding of the types of risks that investors assume when they put money into a bond fund. There are several varieties of dangers, and they don’t apply to all categories of fixed-income portfolios to the same degree.
Take credit risk, perhaps the most obvious type of danger. This measures a borrower’s ability to pay back principal when due and make all interest payments on schedule. In other words, it estimates how likely an issuer would be to default on its debts.
Several rating services evaluate the financial strength of corporations and municipalities (state and local governments) and rate their bonds accordingly. Standard & Poor’s, for example, ranks bonds from AAA down to D (for issues in default). Anything below BBB is considered speculative, “junk” or “high-yield” debt. Why high-yield? Because riskier issuers must offer a higher interest rate on their bonds to entice investors to buy them.
Just keep in mind that higher yields won’t necessarily translate into superior total returns. When bonds prices fall, for whatever reason, that can more than offset the interest income received, resulting in a net loss for the holder.
That’s been happening lately to junk bond mutual funds, many of which have fallen flat on their faces despite paying double-digit yields. “Many fund investors look too closely at yield when they should be focusing on total return instead,” notes Dave Schulz, manager of the Milwaukee-based Newton Income Fund.
For all practical purposes, Treasury bonds and other debt issues directly backed by Washington carry no risk of default.
But it doesn’t mean these bonds are necessarily “safe.” Some people assume that government securities and the funds that hold them can’t drop in price. Not so. All bonds, even Treasuries, fluctuate according to interest rate movements. Picture a seesaw with interest rates on one seat and bond prices on the other. When one goes up, the other goes down.
Individual bonds, and thus bond funds, carry different amounts of interest rate risk. Several factors come into play, especially time remaining until a bond matures. That is, long-term bonds drop more sharply than short-term ones when there’s an increase in the general level of rates.
The Benham fund group of Mountain View, Calif., provides an example. When market interest rates rise by 1 percentage point, a one-year Treasury will drop in value by roughly 1%, a 10-year Treasury will decline by 6.5% or so and a 30-year will tumble 10%. But if rates ease by one percentage point, the reverse would happen: Prices would climb by about the same magnitude.
When shopping for fixed-income funds, inquire about the “average maturity,” expressed in years, of the bonds held. The annual report may list this information, or you can check with a representative of the fund company.
You might also ask about the portfolio’s “duration,” a more accurate measure of interest rate risk, Schulz says. Trying to calculate duration can get complicated, so just keep in mind that lower numbers represent less volatility. Newton Income, for example, has a duration of 3, which indicates that the fund’s price would rise or fall by a modest 3% or so if rates changed by one percentage point, Schulz says.
Portfolios with relatively long average maturities of, say, 20 years or more will expose you to greater interest rate risk, for better or worse. Short-term funds, which hold bonds coming due within a year or two, offer the most price stability. The trade-off, of course, is that short-term funds usually pay lower yields and don’t rise as much during a bond market rally.
Credit and interest rate risk are the big ones. But bond fund investors face additional dangers. These include:
* Currency risk. Portfolios that hold foreign debt securities usually slip in value if the U.S. dollar rises. Conversely, a declining greenback tends to push up the prices of international bonds and bond funds.
Ironically, many advisers recommend having some exposure to foreign bonds, because this can increase your overall diversification and profit potential. Think of it this way: If you don’t have any foreign holdings, you’re essentially betting that the U.S. bond market will post the best returns in the world in any given year. That rarely happens.
* “Call” risk. This is the threat that a bond might be redeemed by the issuer before maturity. In return for having to surrender the bond, the holder typically receives a payment that includes a slight premium to the face value.
Is this bad? It can be, because issuers usually call bonds only after interest rates have dropped, allowing them to replace costly debt with bonds paying lower rates.
Corporate bonds that face possible calls in the near future might not appreciate much in a bond market rally. “You don’t get the same upside price movement on corporates as with governments, which generally aren’t callable,” says George Stasen, chief operating officer of the Rushmore group in Bethesda, Md., which offers a mutual fund that holds nothing but Treasury bonds.
In fact, governments as a group have slightly outperformed higher-rated corporate bonds on a total-return basis from 1972 on, Stasen says, citing numbers supplied by Shearson Lehman Hutton. That’s odd, because corporates carry credit risk and thus should offer higher returns to compensate investors. Stasen attributes this anomaly to the fact that corporates, unlike Treasuries and many other government issues, can be called away, depriving investors of market profits.
Certain municipal bonds also face call risk. In fact, some observers estimate that 20% to 40% of the current supply of munis could be retired prematurely by the mid-1990s. If so, that might cause problems for investors in tax-free bond funds. A broker can tell you whether a specific bond has call provisions, but it’s harder to size up an entire mutual fund.
Clearly, the bond market isn’t monolithic; different types of debt carry different degrees of risk. “There’s a lot to be said for the flexibility to move between fixed-income sectors,” says Rodriguez, who can do so in the FPA New Income Fund. “Few people realize that when they invest in a specific type of bond fund, they’re really investing in a narrow sector portfolio.”
That’s a good argument for holding a couple of types of bond funds, or at least one that can move around as the risk-return trade-off changes.
BOND RISK What makes some bond funds more risky than others? Usually, the more volatile portfolios hold a large proportion of long-term bonds, lower-rated issues or a combination of the two.
The following table lists some of the lowest- and highest-risk bond funds around, as identified by Mutual Fund Values, a publication of Morningstar Inc. in Chicago. Significantly, portfolios in the latter group tend to have more erratic long-term returns. However, this doesn’t mean volatile fixed-income funds necessarily make less suitable investments--that depends on each person’s tolerance for risk.
LOWER-RISK FUNDS Name: Smith Barney Income Return (800) 544-7835 Types of Bonds Held: Governments, top-rated corporates Five-Year Total Return: +49% Sales Charge: 1.25% Minimum Investment: $10,000 Name: T. Rowe Price Short-Term Bond (800) 638-5660 Types of Bonds Held: Governments, top corporates,some foreign Five-Year Total Return: +48% Sales Charge: None Minimum Investment: $2,500 Name: Vanguard Fixed-Income Short-Term Bond (800) 662-7447 Types of Bonds Held: Governments, better-rated corporates, some foreign bonds Five-Year Total Return: +57% Sales Charge: None Minimum Investment: $3,000 Name: Lord Abbett Bond-Debenture (800) 874-3733 Types of Bonds Held: Governments and corporates, including bonds convertible into common stock Five-Year Total Return: +52% Sales Charge: 7.25% Minimum Investment: $1,000 Name: Twentieth Century U.S. Governments (800) 345-2021 Types of Bonds Held: Treasuries and bonds issued by government agencies Five-Year Total Return: +46% Sales Charge: None Minimum Investment: None HIGHER-RISK FUNDS Name: Colonial Income Plus (800) 248-2828 Types of Bonds Held: Governments and corporates, including junk bonds Five-Year Total Return: +38% Sales Charge: 6.75% Minimum Investment: $250 Name: National Bond (800) 356-5535 Types of Bonds Held: Governments and corporates, including junk bonds Five-Year Total Return: +6% Sales Charge: 4.75% Minimum Investment: $250 Name: Venture Income Plus (800) 545-2098 Types of Bonds Held: Corporates, including junk and unrated bonds Five-Year Total Return: +21% Sales Charge: 4.75% plus 0.25% for 12b-1 fee Minimum Investment: $1,000 Name: Shearson Lehman Hutton Investment-Grade Bond (212) 528-2744 Types of Bonds Held: Better-rated corporates, various Five-Year Total Return: +74% Sales Charge: 5% (deferred) plus 0.75% for 12b-1 fee Minimum Investment: $500 Name: American Capital High Yield (800) 421-5666 Types of Bonds Held: Corporates, mainly junk bonds other securities Five-Year Total Return: +22% Sales Charge: 4.75% plus 0.25% for 12b-1 fee Minimum Investment: $500 Five-year total return figures, for the period ending in March, 1990, are provided by Morningstar Inc. HOW MUTUAL FUNDS PERFORMED Average total return, including dividends, in percent for periods ended Thursday, May 24 TOP 10
Fund Type Notes 12 mos. Yr.-to-date Week SLM Aggressive Growth CA L 22.90% 8.65% 6.55% Fidelity Select Telecomm. TK LL,R 10.46 -5.64 5.83 Seligman Comm. & Information TK L 23.32 16.24 5.77 MFS Lifetime Emerging Growth SG NL,R 22.31 16.88 5.62 Dean Witter Developing Growth SG NL,R 20.80 17.52 5.49 CGM Capital Development G NL 24.55 18.84 5.46 Twentieth Century: Giftrust G NL 20.07 4.94 5.38 Prudent Speculator: Leverged SG NL -13.11 1.82 5.35 Eagle Growth Shares G L 7.73 -2.94 5.31 Putnam Information Sciences TK L 15.65 6.86 5.22
BOTTOM 10
Fund Type Notes 12 mos. Yr.-to-date Fidelity Deutsche Mark Perform. WI LL *% 3.29% Dillon Reed: European Equity EU NL N/A 7.50 US Global Resources AU NL,R 2.54 -13.51 Fidelity Select Elec. Util. UT LL,R 9.92 -6.83 Merrill Retirement Global: B WI NL,R 12.10 -1.09 Merrill Retirement Global: A WI NL 13.06 -0.84 National Real Estate: Income S L -16.75 -9.41 GT Global: Europe EU L 30.75 3.47 Eaton Vance Total Return GI L 13.67 -5.02 US Real Estate Fund RE NL -12.10 -7.43
Fund Week Fidelity Deutsche Mark Perform. -1.83% Dillon Reed: European Equity -1.55 US Global Resources -1.54 Fidelity Select Elec. Util. -1.46 Merrill Retirement Global: B -1.37 Merrill Retirement Global: A -1.37 National Real Estate: Income -1.28 GT Global: Europe -1.22 Eaton Vance Total Return -1.17 US Real Estate Fund -1.17
TYPE: AU=gold, B=balanced, CA=capital appreciation, CV=convertible securities, EI=equity income, EU=European regional, FI=fixed income, FS=financial securities, FX=flexible portfolio, G=growth, GI=growth and income, GL=global-international and U.S. stocks, GX=global flexible portfolio, H=health/biotechnology, I=income, IF=international, MI=mixed income, NR=natural resources, OI=option income, PC=Pacific regional, RE=real estate, S=specedlty/misc., SG=small company, TK=science and technology, UT=utility, WI=world income.
NOTES: NL means no sales charge, LL means sales charge of 4 1/2% or less; L means sales charge of greater than 4 1/2%; R means redemption fee may apply.
*Fund not in existence for period covered
N/A: Net asset value not available
Source: Lipper Analytical Services
