Bond Options for the Risk-Averse
If you listen closely enough, you can hear the rumbling of investors migrating from one area of the fixed-income market to another.
A sharp drop in short-term interest rates got the herd moving. Yields from money market funds, bank accounts and similar products are now substantially less than what’s available on bond mutual funds. Better yet, many prognosticators believe that long-term interest rates could decline in the months ahead, and that would result in capital gains for bond fund investors. No wonder sales of bond funds are at a four-year high.
Risk-averse investors should be careful moving around the fixed-income arena, however. “People buy bonds to diminish risk, but they’re kidding themselves to a considerable degree,” warned Melvin A. Gladstone of Gladstone Managed Investments in Berkeley. That isn’t to suggest avoiding all bond funds. Some are remarkably consistent, but it is important to appreciate the dangers.
If you’re looking to sink some cash into a bond fund, determine which of the following key risks apply. You should be able to spot this information fairly easily by scanning the fund’s prospectus or marketing literature. All of these factors can cause price declines:
-Interest rate risk. This is the danger that rising rates, often linked to accelerating inflation, will erode the market value of a fixed-income security. All bond funds face this uncertainty, but it’s worse for those that invest in long-term debt.
-Credit risk. Unless a fund holds only Treasuries or bonds issued by certain U.S. government agencies, it could see some of its holdings slip into default. Portfolios packed with lower-rated junk bonds face the greatest credit uncertainty.
-Currency risk. This is the danger that the dollar will appreciate against other currencies, undercutting the value of foreign holdings. It applies only to global bond funds, yet this is one of the fastest-growing categories, with assets having doubled from a year ago.
-Prepayment risk. This pertains to mutual funds that invest in bonds issued by the Government National Mortgage Assn. (Ginnie Mae) and similar agencies. “This (risk) means that significant declines in interest rates will almost certainly induce some homeowners to prepay their mortgages in order to refinance them at lower rates,” explains John Bogle, head of the Vanguard Group. Such refinancings can undercut the returns available on mortgage funds by stripping them of bonds at the most favorable time--when interest rates are falling.
Understanding which types of securities a fund holds is half the battle. With a bit more effort, you can gauge bond risk in more precise, numerical terms. Thomas M. Poor, manager of the Scudder Short-Term Bond Fund in Boston, suggests that you focus on a volatility yardstick known as “duration.” This is a calculation in which you determine the present value of a bond’s future interest payments and principal repayment. Sound complicated? It is. Suffice it that bond funds with lower duration numbers are less volatile.
According to Poor, money market funds have a duration of zero, while a portfolio filled with 30-year Treasury bonds would have a duration of 10. If interest rates rose by one percentage point, that Treasury portfolio could be expected to lose about 10% in capital value, while a one-percentage-point drop in interest rates would produce about a 10% price gain. “Duration gives you a pretty good approximation of risk,” says Poor, whose conservative fund has a duration of 2.1.
Unfortunately, you might have trouble tracking down duration numbers. Mutual fund research publications and newsletters generally don’t calculate these figures. Some fund companies will divulge the information if you ask, but others might not.
As a simpler and more accessible risk measure, simply watch how the fund’s price behaves. Various research publications and financial magazines track total return numbers for stock and bond funds, usually on a quarterly or annual basis. A handful of computer software packages geared to mutual funds typically have even more such information.
You can get a good sense of volatility by checking how a fund fared during tough times in the bond market, such as 1980, 1981, 1983 or 1987. Some bond funds have not had a single down year during the past decade. Although rising interest rates at times resulted in losses that wiped out part of their yields, they were able to pull through with positive total returns. The accompanying chart lists some of these consistently profitable portfolios.
If you’re simply looking for a money market substitute without wanting to assume much more risk, pay special attention to short-term bond funds. These products, which started to become popular in the latter half of the ‘80s, generally hold debt maturing in less than three years. That makes them much less volatile than the typical fixed-income portfolio, which might go out 20 years or more.
Gladstone recommends short-term funds as a place to park cash while earning better returns than on money market securities. His favorites include the short-term funds offered by Vanguard (800-662-7447) and Neuberger & Berman (800-877-9700), both of which are no-loads--that is, they charge no up-front fees.
Gladstone believes that investors can strike a nice balance with a combination of short-term bond portfolios for safety and stock funds for growth. “I don’t like long-term bonds and bond funds,” he says. “I think they’re much more risky than people realize.”
These bond funds are among the most steady, having returned at least 5% (including interest) each year from 1986 through 1990.
Avg. Gain Sales Fund Per Year* Load Minimum Phone Composite Income +7.8% 4% $1,000 800-543-8072 FPA New Income +10.1% 4.5% $1,500 800-421-4374 Fund for U.S. Govt. Securities +9.1% 4.5% $500 800-245-5051 T. Rowe Price Short-Term Bond +7.1% None $2,500 800-638-5660 Smith Barney Income Return +9.0% 1.5% $10,000 800-544-7835 Sit New Beginning Investment Reserve +7.0% None $2,000 800-332-5580
* Figure is for the five years ending June 30 and excludes the impact of sales loads, if any. The average bond fund rose at a 7% compounded annual rate in the period. Source: Lipper Analytical Services.