QUARTERLY STOCK MUTUAL FUND REVIEW : Eroding Share Prices Set Bond Investors Aquiver
The mutual fund industry’s greatest concern right now isn’t whether some small percentage of stock fund investors will decide to cash out.
The bigger worry is how millions of conservative investors in bond funds will react to the news that they’re losing money, as surging market interest rates devalue older bonds.
Bond funds “are where the real crisis is,” says Eric Kobren, head of the Mutual Fund Investors Assn., a fund newsletter publisher based in Wellesley Hills, Mass.
In the first quarter, the average stock fund fell 3.35%, the largest quarterly loss since the third quarter of 1990. But in theory, anyway, most stock investors understand that they’re taking a risk of loss in the market.
The same may not be true for bond fund investors. Many of them bought into high-yielding bond funds in recent years simply as substitutes for low-yielding bank certificates of deposit.
Substitution was fine as long as market interest rates were falling, which they did from 1990 through most of last year. Bond fund investors earned their high yields, and their principal (the money originally invested) also increased because older, higher-yielding bonds appreciated in value.
But now market interest rates are rising rapidly, as the economy expands and investors fear higher inflation. The result is that bond mutual fund share prices are sliding, eroding investors’ principal--and their willingness to stick with the funds.
Michael Lipper of fund-tracker Lipper Analytical Services in New York says preliminary figures show that the average bond fund had a “negative total return” of 2.53% in the first quarter. That means that despite the interest earned on its bonds during the quarter, the average fund’s share price fell enough to effectively wipe out the interest earnings, and then some.
The damage was much worse for some types of funds, as the accompanying chart shows. The Dreyfus General Municipal bond fund was off 6.2% for the quarter; the Vanguard Long-Term Treasury fund dove 5.6%. Many bond funds are showing their largest losses in seven years.
Naturally, funds that own bonds maturing farthest in the future have been slammed hardest, because longer-term fixed-rate bonds depreciate most rapidly when market rates begin to rise. That makes sense, if you think about it: The longer a bond’s term, the greater investors’ fear of being stuck with its fixed yield while higher-yielding opportunities become available in the interim.
So potential buyers are dropping the prices they’re willing to pay for bonds, depreciating the market across the board.
Should most bond investors care if their underlying principal is eroding? If they’re investing solely for current income, they may not. They’re still getting paid their interest--anywhere from 4% to 8% annualized, depending on the type of fund--even if it’s being used to buy more shares (i.e., it’s being “reinvested”).
Also, if the bond market is overreacting to the economy’s strength, market interest rates could soon begin to fall back, which means bond fund share prices would appreciate again, though not necessarily back to their peak levels of 1993.
Lipper believes that conservative, risk-adverse older individuals who are solely invested in long-term bond funds ought to instead build a “laddered” portfolio: Sell one-half to three-quarters of your long-term fund, even if it means taking a loss, and reinvest half the proceeds in a short-term bond and half in an intermediate-term fund.
Though short-term interest rates have been rising with long rates, shorter-term bonds don’t depreciate anywhere near as fast as long-term bonds in this kind of environment. You’ll earn a lower yield on shorter-term bonds, but your principal will be more stable.
For example, Vanguard Group’s long-term municipal bond fund has suffered a loss (negative total return) of 6% this year. But the firm’s short-term muni fund is down just 0.1%. The long-term muni fund currently yields 5.5%, while the short-term muni fund yields 3.2%. By blending a portfolio of short-, intermediate- and long-term bond funds you can earn a mid-range yield while protecting against deep principal losses.
Some experts, however, believe that truly conservative investors who can’t stand to lose any principal ought to just admit they were wrong to buy a bond fund, sell it, and go back to a bank CD.
“If you really don’t belong in it, get out,” Kobren advises. The mental agony such bond owners now face is “just not worth it,” he says.
The Times will present a detailed report on first-quarter bond fund performance on Thursday.
Trouble in Bond Land
How some of the largest bond mutual funds fared in 1993 and in the first quarter of 1994.
Total investment return Fund 1993 1st qtr. Dreyfus General Muni +13.3% -6.2% Vanguard Long-Term Treas. +16.8% -5.6% Dean Witter Cal. Tax-Free +11.0% -5.1% Fidel. Inv.-Grade Bond +16.2% -4.6% T. Rowe Price High-Yield +21.8% -4.2% Dean Witter U.S. Govt. +7.1% -3.2% Franklin Cal. Tax-Free +9.5% -3.1% Franklin U.S. Govt. +6.9% -2.8% AARP GNMA +6.0% -2.5% Kemper U.S. Govt. +6.3% -2.4%
Source: Lipper Analytical Services, Inc. First-quarter figures are preliminary.
