ASSESSING THE INFLATION THREAT : Commodity Hikes No Bond Fund Concern

By all rights, bond mutual fund investors shouldn't have it this good.

Prices of key commodities have surged this year, which usually means that higher inflation--the scourge of fixed-income investors--is in the pipeline.

But investors who have stayed put in bonds just keep making money.

In the first half of the year, the average U.S. government bond mutual fund earned a total return of 6.59%, a full two percentage points above the 4.58% return on the average stock fund, according to fund-tracker Lipper Analytical Services.

The average government bond fund return was about 3.3% in interest earnings (i.e., half the 6.6% annualized yield the typical government fund is paying) and another 3.3% in price appreciation, as falling market interest rates boosted the value of older bonds.

Investors in long-term corporate and municipal bond funds have likewise been rewarded. Funds that own high-quality corporate bonds gained 7.81% in the first half, and the average California muni-bond fund's return was 7.64%.

Even on Tuesday, as commodity prices rocketed anew, long-term bond yields responded only grudgingly. The yield on the Treasury's 30-year bond closed at 6.68%, up just slightly from 6.66% last Friday and way down from 7.39% at year's end.

In theory, anyway, the threat of higher inflation should push interest rates up, to compensate bond owners for the erosion of their fixed returns. Rising rates devalue older bonds, thus producing widespread losses--at least on paper--for bond fund owners.

But long-term interest rates have continued to ratchet lower, despite periodic commodity-inflation scares since late February. Each time bond yields moved up even slightly, buyers have rushed in.

"Every blip has been a head-fake," says David Schroeder, manager of the Benham Treasury Note fund in Mountain View, Calif.

Clearly, the bond market so far doesn't view rising commodity prices as a cause for real concern. In a still-sluggish economy, many bond investors simply don't believe that commodity price hikes can stick.

The consensus expectation of bond pros is that the economy continues to grow moderately at best through the end of the year. And that is a recipe for stable, long-term interest rates, many analysts believe.

But there's a big unknown in this picture, and that's the trend in short-term interest rates. Tuesday, yet another rumor swept Wall Street that the Federal Reserve is eager to push short rates slightly higher, for the first time in more than four years.

The Fed has signaled in recent months that the next move in short rates is likely to be up from the current 3% range, as the economy gradually improves.

Almost everyone on Wall Street appears to be mentally prepared for rising short rates.

"We think we're probably seeing the bottom in (short) rates," agrees Michael Kennedy, manager of the SteinRoe Government Income fund in Chicago.

Just the same, some fund managers also have been hedging their bets, looking for ways to protect their portfolios from rising rates.

Two common themes:

* The "barbell" approach. Steven Nothern, senior vice president at the MFS Government Securities fund in Boston, has shifted his portfolio heavily into 10- to 20-year Treasury bonds at one end and into very short-term mortgage securities at the other.

Where the portfolio is under-weighted is in the middle: one- to five-year Treasury securities, for example.

If the Fed pushes short-term rates up, Nothern figures, bonds of shorter maturities would be affected most, because investors either will seek the safety of very short-term issues, or they'll rush out the "yield curve" toward the highest-yielding, longest-term bonds.

* Load up on "cheap" bonds. Many bond fund managers have begun trading their Treasury securities for mortgage-backed bonds and other bonds that offer better yields than Treasury issues.

SteinRoe's Kennedy figures mortgage bonds are a good defense against rising rates, because if market rates move up, fewer homeowners will choose to pay off their mortgages early. Heavy prepayment rates have caused many investors to shy away from mortgage bonds in recent months, keeping their yields high.

Still, bond experts caution that no portfolio strategy is foolproof. If interest rates begin to rise, the relative calm in the bond market for the past three years will be shattered.

And let's not forget: Many or most bond fund managers have never lived through a bear market. (The trend in interest rates has been down, after all, since 1981.)

"I don't think you should buy the vast majority of bond funds on the basis that the manager will be able to pull the trigger" at the right time, says Michael Lipper of Lipper Analytical.

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