Paper Losses Leave Bond Investors Wondering

Phoenix investor Wesley Phillips made his first foray into bond mutual funds last year. So far, his experience hasn’t been an especially pleasant one.

Phillips’ adventure began in May, when he started moving money out of certificates of deposit into two Franklin tax-free funds in search of higher returns. He later added to those positions and put some cash into a third fund, Franklin Income, which holds bonds and higher-yielding stocks.

Although all three funds have good track records, that was of little consolation when interest rates started to push higher in October and accelerated their rise in early February.

Because interest rates move inversely to bond prices, the latest trend has hurt nearly all bond fund investors.

“I understood (at the time of purchase) that bond funds could fluctuate in price,” says Phillips, who invested $250,000 in the three funds and has lost nearly $4,000 in principal, excluding the sales commissions he paid.

“What I didn’t realize that interest rates were so low they could only go up.”

In this sense, he’s not alone. Investors pumped a record $144 billion into bond funds in 1993 and many of them, like Phillips, may be wondering if they can ever recoup their paper losses.

The answer, of course, is yes. Bond funds can appreciate as quickly as they have dropped in recent weeks, assuming the interest rate trend turns favorable. The hard part, of course, is predicting whether that will happen.

Terry Anderson, branch manager at brokerage Diversified Securities in Tustin, says he’s modestly concerned about rising interest rates and is cautioning his clients about government bond funds, which have a somewhat undeserved reputation for being “safe.” While the bonds owned by these funds aren’t going to go into default--eliminating one type of risk--they nevertheless would be hurt by rising interest rates.

C. Frazier Evans, senior economist for the Colonial fund group in Boston, offers a more optimistic outlook. He expects to see a bond market rally developing by the second half of 1994, fueled by three catalysts: continuing low inflation, a shrinking federal deficit and a slowing economy later this year.

Similarly, Richard Schlanger, a bond fund manager for the Boston-based Pioneer group, thinks this year’s bond market slide has been overdone. He sees the possibility of “rough water ahead followed by a calm.”

Regardless of your forecast for interest rates, it’s important to diversify your bond fund holdings among different segments of the market. For example, Anderson and Evans like the idea of multisector or flexible bond funds, which tend to hold a mix of U.S. government bonds, foreign government bonds and lower-rated or “junk” domestic debt.

Tax-exempt municipal bond funds also remain attractive despite lower prices in recent weeks, say Evans and Anderson. Higher tax rates this year have boosted demand for these securities, while the supply of new bonds coming to market is expected to contract to $180 billion this year from a record $290 billion in 1993, according to Evans.

In addition, risk-shy investors should be careful not to put all their marbles in long-term bond funds. Though short-term portfolios pay lower yields, they don’t get bruised as much when interest rates do rise.

Conservative investors, even retirees, might also consider having a small stake in stock funds.

For clients who don’t have to live off every dime of income, Anderson recommends some stock fund holdings as a longer-term inflation hedge and diversification move.

As a general rule, Evans suggests subtracting your age from 110, and putting that much of your portfolio in stock funds. For Phillips, 70, that would work out to a 40% equity stake.

Sheldon Jacobs, publisher of the No-Load Fund Analyst newsletter in Irvington-on-Hudson, N.Y., also recommends a 40% stake in stock funds, including those that venture into international markets, within his retirement model portfolio. He suggests another 20% in income funds, which are dominated by bonds but also include some equity holdings, and just 40% in pure bond products.

By contrast, the new Stagecoach LifePath 2000 Fund from San Francisco-based Wells Fargo Bank is more conservative. This portfolio is designed for people in their 50s and 60s who anticipate they will retire or otherwise need the money around the year 2000. Though its allocation mix will fluctuate, the fund is expected to maintain a stock exposure of about 20%.

And you could come up with many more allocation examples for conservative investors.

The main point is to realize that the vast majority of fixed-income funds will drop in price if interest rates continue to rise. Yet the extent of price damage will vary by the average maturity and types of bonds held, which makes diversification a good rule for even risk-shy individuals.

The Century City-based Pilgrim Group of mutual funds has lost its court battle with mutual fund rating service Morningstar Inc. of Chicago, which Pilgrim alleged had libeled it.

Pilgrim sued Morningstar a year ago, charging that Morningstar had damaged the company with a newsletter report that questioned the accuracy of some of Pilgrim’s fund advertisements.

Pilgrim wanted a trial to prove its point. But in a decision Friday from the California Court of Appeal for the second appellate district, the company’s suit was ordered dismissed.

Morningstar, as a publisher, had asserted its First Amendment right to question Pilgrim’s ads, and the court agreed that Morningstar’s analysis was “non-actionable.”

Pilgrim, which manages $2.8 billion, has been embroiled in a number of controversies over its funds in recent years.

The company issued a terse statement Sunday indicating that it will not attempt to appeal the court decision.

“As far as we are concerned, the matter is now closed, and we shall continue to focus our efforts on delivering top performance to our shareholders,” Pilgrim said.

Measuring Bond Viability

Virtually all bonds and bond mutual funds decline in price when interest rates rise, just as they appreciate when the rates drop. However, the magnitude of any fluctuations depends on the type of debt instrument, especially its maturity. Here is roughly how much principal loss various bonds and mutual funds would see if interest rates rose by one percentage point.

5-year Treasury: -2.4%

10-year Treasury: -6.1

30-year Treasury: -11.9

10-year municipal (rated AA): -6.9

30-year municipal (rated AA): -13.4

Average municipal fund (long-term): -9.0

Average GNMA fund (intermediate term): -3.5

Sources: Porter Pierpont Morgan, Liberty Financial Cos.