1992’s Bond Fund Earnings Contain a Caveat to Investors

For millions of bond mutual fund investors, 1992 demonstrated that you can lose money in bonds and not know it. And therein lies the warning for 1993.

Thanks to still-high interest rates, most bond fund owners earned between 5.5% and 9% on their investment last year, according to figures released Thursday by fund-tracker Lipper Analytical Services in New York. In general, corporate and municipal bonds paid more, Treasuries less.

But while the numbers are respectable, they hide an erosion in the share prices of many bond funds, as market interest rates gyrated and the value of some types of bonds declined.

The result: Many fund shareholders actually sacrificed a little of their principal last year. However, the funds earned enough interest income to more than cover the principal loss.

For example, the largest category of bond funds--the 129 funds that own long-term U.S. government securities, including Treasury bonds--posted an average share price decline of 0.83% last year, according to Lipper.

But because the typical U.S. government fund earned interest of about 7% on its bonds during the year, the net “total return” after accounting for the share price drop was 6.25%, Lipper said.

Though the share price erosion was slight in most cases, bond experts warn that the damage could be far worse this year if the recovering economy pushes market interest rates up, thereby depressing the value of older, lower-yielding bonds.

In fact, a sudden jump in rates Thursday, as investors reacted to a surge in new borrowing by corporations, caused a fright in the bond market.

“In 1993, there is relatively little margin for error with bonds,” said Robert Rodriguez, who manages the First Pacific Advisors New Income Fund in Los Angeles.

If the economy grows faster than expected, or if President-elect Bill Clinton fails to deliver a plan to rein in record federal borrowing, interest rates could continue to rise, Rodriguez said.

The big question, he noted, is whether the hordes of new investors who’ve poured into bond funds in recent years are prepared to see a much more severe drop in their principal--even if it only lasts a short time.

Indeed, while stock mutual funds get most of the publicity, assets of bond funds now total $563 billion, well above the $457 billion in stock funds. And last year, monthly purchases of bond fund shares routinely topped even the huge sums going into stock funds.

If you have money in a bond fund, and especially if you’ve owned the shares for years and have never had reason to question your investment, many experts advise that you take another look at what you own, and why you’re there. Two questions to ask:

- Does the fund take more “interest rate” risk than you can handle? You should know your fund’s “average maturity”--the average life of the bonds in the portfolio. Funds that are reaching for the highest possible yields will typically own the longest-term bonds, because that’s where the highest returns can be found.

But if interest rates rise across the board this year, longer-term bonds will drop much faster in value than shorter-term bonds. If you can’t handle a substantial drop in principal value, you shouldn’t be in a fund that has an average maturity of greater than seven years or so, many experts say.

- Do you own the right types of bonds for a changing economy? Many investors have assumed in recent years that they’re safe owning funds that simply buy short- and intermediate-term Treasury bonds.

But while the government always makes good on its interest payments, that doesn’t protect you against changes in the market price of the bonds.

If interest rates rise with the recovering economy, owners of corporate bond funds may have an edge this year--because corporate bonds typically already pay more than government securities, and the value of corporate bonds can rise as the financial health of the companies issuing them improves.

With corporates, “you can get benefits from a rising economy, which you’re not going to get in Treasuries,” says Don Phillips, editor of the Mutual Fund Values newsletter in Chicago.

In fact, high-yielding corporate junk bonds, the best bond fund category last year, could repeat again this year, many experts believe.

Bond Fund Yields Hide Price Erosion

Some of the most popular bond mutual fund categories saw their values drop slightly last year, as interest rates gyrated. High interest earnings kept the funds total return positive, however.

‘92 Price Change ’92 Total Return U.S. Govt. Securities -0.83% +6.25% GNMA Bonds -1.17% +6.50% Foreign Bonds -5.24% +2.79%

Source: Lipper Analytical Securities

How Bond Funds Fared

Here are total returns--interest earned, plus or minus net price change--for key categories of bond mutual funds for 1992 and for the last five years. Also shown: the average 12-month yield for each category.

Fund category Total return: 12-mo. (No. of funds) 1992 5 years yield Junk corp. bonds (78) +17.7% +59.8% 10.5% General munis, long-term (135) +8.7% +57.3% 5.9% Mixed bonds (25) +8.6% +60.8% 7.7% Calif. munis, long-term (60) +8.4% +56.0% 6.0% Lower-quality corp., long-term (60) +8.1% +63.1% 7.3% High-quality corp., long-term (64) +7.2% +63.7% 7.0% High-quality corp., 5- to 10-year (62) +6.9% +59.4% 6.6% GNMA securities (42) +6.5% +63.9% 7.5% U.S. govt., long-term (129) +6.3% +57.6% 7.0% U.S. govt., 5- to 10-year (41) +6.1% +55.5% 6.7% High-quality corp., 1- to 5-year (72) +5.9% +49.5% 6.2% U.S. govt., 1- to 5-year (58) +5.3% +50.0% 5.7% Adjustable-rate mortgages (52) +4.7% +49.4% 6.2% Money mkt. (264) +3.3% +37.0% 3.2% World bonds (53) +2.8% +48.3% 8.7%

Source: Lipper Analytical Securities