Bonds and Funds That Buy Them Head South as Interest Rates Climb

Mutual funds that invest in bonds have had a nice run.

Years of low inflation and falling interest rates have well rewarded those investors who abandoned money market funds and bank certificates for the more promising yields of the bond market.

Bond fund returns grew on the strength of solid yields and rising demand for instruments paying anything more than the paltry 3% or 4% the banks had been promising.

But that trend has reversed. Bonds and the funds that buy them have headed south and might keep going that way if interest rates are set for the prolonged rise that some prognosticators see.

When interest rates rise, the prices of bonds fall as new, higher yielding bonds hit the street and compete with the lower yielding bonds already out there. For some investors, this means timing the market--pulling out of bonds altogether when they expect rates to rise.

But most bond fund investors prefer a less drastic alternative. Wary of betting everything on uncertain interest rate predictions and determined to keep at least some of their portfolio in the bond market, they are looking for ways to stay in bonds without losing their shirts in a rising rate environment.

“The choices are somewhat limited,” says John Markese, president of the American Assn. of Individual Investors in Chicago. “Primarily, you can look down the maturity scale.”

Because longer-term bonds are most responsive to interest rate fluctuations, the shorter the average maturity of the bond portfolio, the less volatile the fund is likely to be.

Markese suggests that investors wary of rate hikes move to intermediate-maturity portfolios.

“If you stay in the five- to seven-year range, you’ll maximize return and reduce the risk you would be taking for going the extra way out on the maturity spectrum,” says Markese.

Even that move to shorter maturities may be less easy than it sounds. Steve Schoepke, senior analyst with Moody’s Investor Service, New York, points out that one can’t always tell by a fund’s name exactly how long- or short-term its portfolio is.

You can check in Morningstar’s mutual fund guides, available at many public libraries, for the average portfolio maturity of a bond fund.

A second step to protecting a bond fund portfolio involves skirting the funds that are the most interest-rate sensitive.

Typically, these are funds that buy long-term zero-coupon bonds--instruments that gather no quarterly or semi-annual interest but pay off in a lump sum when the bond matures.

“They are the most volatile,” says Markese.

This year, there are bond funds on the market that leverage their interest rate sensitivity by including derivative products--artificial financial instruments that are created from pieces of other bonds and may reflect underlying or unrelated indexes.

“Clearly these leveraged products will move a multiple of the interest rate movement,” notes Gary Arne, a director in the managed funds group at Standard & Poor’s, New York, a investment rating firm.

Arne also recommends that investors steer clear of bond markets that are said to be illiquid, although he concedes this measure can change rapidly over days or weeks.

A temporary uncertainty in the municipal bond market, for example, can put a gap between the bid and asked price throughout the whole market that may not be warranted by interest rate increases or other fundamental issues.

Finally, bond fund investors would do well to pick the funds that seem less volatile over long periods, though finding them is a challenge.

Standard & Poor’s recently began issuing volatility rankings on bond funds it studies.