Bond Fund Risk: No, This Time We Really Mean It

Wall Street’s dramatic bond rally has gone on longer than almost anyone would have predicted three years ago. So when market pros warn today that interest rates finally are bottoming, individual investors may be excused for scoffing.

They’ve heard it a hundred times before. Yet they keep making money in bonds.

Even so, third-quarter performance results for bond mutual funds--which have, for better or worse, replaced bank CDs for millions of income-hungry Americans--suggest that this time the Cassandras are on to something.

The average long-term U.S. Treasury bond fund posted a total return of 4.39% in the third quarter, according to fund tracker Lipper Analytical Services in Summit, N.J. Total return counts both interest income earned and price change.


That spectacular three-month return was the result of a sharp drop in 30-year Treasury bond yields during the quarter, which boosted the value of older bonds. Year-to-date, the typical long-term Treasury bond fund has scored a 14.4% return--only about 4.5 percentage points of which represent interest earnings. The rest is price appreciation in the bonds.

Yields on long-term municipal and corporate bonds also dove last summer, as did foreign yields. Hence, those funds top the winners list for total return in the quarter. Results were less exciting for funds owning short-term (one- to five-year) and intermediate (five- to 10-year) bonds.

So what’s the problem? This: Long-term bond yields are the last interest rates to fall as the economic cycle moves from recession to expansion. That means it’s truly late in the bond game.

The cycle is virtually the same after each recession. Interest rates overall are high, so investors stay in short-term securities. As rates begin to fall, investors are gradually compelled to buy longer-term securities. As the search for yield gets desperate, buyers reach for the longest-term, highest-yielding bonds they can find.


With the 30-year Treasury bond yield now at 6%, down from 7.39% as recently as nine months ago, it’s obvious that a lot of reaching by a lot of investors has been going on.

Tom Sowanick, head of Merrill Lynch & Co.'s taxable-bond area, says he has taken to using the term coiled to describe interest rates today--as in coiled and ready to rebound.

The key word there is ready . Sowanick and other pros don’t necessarily see rates jumping soon. But the decline in rates since 1990, thanks to the weak economy, has left short-term yields at 30-year lows and long-term yields at 20-year lows.

Maybe, before this is over, they’ll go to 40-year lows. Most bond pros doubt it, however. “We think we’ve seen the bulk of the decline in rates,” says Stephen Poling, strategist at the Fortis Advantage Asset Allocation mutual fund in Minneapolis.

Indeed, individual investors might want to take a hint from the asset allocation funds, which are free to mix stock, bond and cash (money market) investments in search of the best possible return for the lowest risk. When they look at bonds today, some of the allocators don’t like what they see.

The Fortis fund, for example, since summer has shifted from 60% bonds (with the balance in stocks and cash) to a mix of 40% bonds, 50% stocks and 10% cash. “We think there’s considerably greater potential in the stock market than in the bond market,” Poling says.

Similarly, the Phoenix Total Return asset allocation fund in Enfield, Conn., now is 54% cash, 43% stocks and just 2% bonds. Manager Robert Milnamow admits that he has been virtually out of bonds for more than a year, so he missed the big rally. Still, he insists, “The market that has the least upside from here is the bond market.”

Why? Back to those market cycles: As the economy grows, interest rates will move up at some point. That’s bad for anyone who owns older, fixed-rate bonds. At the same time, a growing economy means corporate profits will be growing as well. Historically, the stock market has shown it can live with rising interest rates so long as corporate profits are also improving.


Now, this is not to suggest that conservative bond fund owners should suddenly shift all of that money into stock funds. Obviously, there is considerable risk in stocks today as well, with prices near record highs. And besides, most bond investors are there for a reason: They need income.

That’s fine, but what’s important for bond fund owners to realize is that 1) at best, you probably won’t earn more than the current 4% to 7% yields from bonds over the next year (no more share-price appreciation) and 2) if and when interest rates rise, your share price will decline.

If you need to stay in bond funds for the income they provide but can’t stand the thought of losing a lot of principal--even on paper--avoid long-term funds and go with shorter- or intermediate-term funds. An even better idea: Split your bond money evenly among a long-term fund, an intermediate-term fund and a short-term fund. That way, no matter what happens with interest rates, you’ve spread your risk.

How Bond Funds Fared

Here are average total returns for key categories of bond mutual funds for three periods ended Sept. 30. Total return includes interest earnings plus or minus any change in the bonds’ principal value.

Average total return Fund category 3rd qtr. 9 mos. 5 yrs. Global, long-term +4.40% +13.3% +66.3% U.S. Treasury only, long-term +4.39% +14.4% +67.8% California muni, long-term +3.60% +11.5% +61.1% High-quality corporate, long-term +3.46% +11.7% +71.0% Lower-quality corporate, long-term +3.42% +12.0% +69.5% General muni, long-term +3.39% +11.1% +61.0% Mixed bonds +2.75% +11.3% +65.9% High-quality corporate, 5- to 10-year +2.70% +9.6% +64.6% U.S. govt. & agency, long-term +2.70% +9.6% +63.6% U.S. govt. & agency, 5- to 10-year +2.31% +8.4% +59.1% Junk corporate +1.91% +14.0% +65.8% High-quality corporate, 1- to 5-year +1.61% +5.8% +53.0% U.S. govt. & agency, 1- to 5-year +1.55% +5.7% +52.5% GNMA +1.04% +6.0% +61.5% Money market +0.64% +1.9% +33.1% Global money market +0.62% +4.2% +53.2%

Source: Lipper Analytical Services Inc.