Options for Bond Fund Owners

When all is said and done about bond mutual fund owners’ miserable first half, more will probably be said than done: Inertia being a strong force, most fund shareholders will probably keep the funds they own.

But if the thought of another large decline in your fund’s principal value is too much to bear, the variation in bond funds’ first-half returns shows that you do have options. Compare, for instance, the relative performance of funds that own long-term U.S. government bonds with those that own shorter-term U.S. government bonds:

* The average long-term U.S. government fund had a negative “total return” of 4.9% in the half, according to fund tracker Lipper Analytical. For an investor in that average fund, the share price fell by a hefty 7.6% in the half as rising market interest rates devalued older fixed-rate bonds.

But the interest income earned by the fund in the period offset part of that decline, so that the final first-half “loss” was 4.9%.

* The average shorter-term U.S. government fund (they typically own securities maturing in one to five years) had a negative total return of 2.1% in the half, as interest income offset about half the 4.3% share-price decline.

Obviously, a loss of 2.1% is easier to swallow than a loss of 4.9%. But to protect more of your principal, you have to give up some yield. Currently, the typical long-term U.S. government fund is yielding about 6.3% (annualized), according to Lipper, while the typical short-term U.S. government fund is yielding about 4.9%.

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The trade-off of owning shorter-term, lower-yielding bonds for greater principal protection is available to investors in government, corporate and municipal bonds, and it may now be a better trade-off than it has been in a while.

The reason: Short-term interest rates have risen much faster than long-term rates this year, as the Federal Reserve Board has tightened credit. The yield on one-year Treasury bills, for example, now is 5.43%, up 1.84 percentage points from year-end. In contrast, the yield on 30-year T-bonds has risen 1.26 points, from 6.35% to 7.61% now.

Robert Rodriguez, manager of the FPA New Income bond fund in West Los Angeles, managed to limit the first-half net loss on his fund to 0.4%, in part by keeping a large chunk of the fund’s assets in safe “cash” securities for much of the period. But Rodriguez now believes that bond yields could hold steady or even come down a bit in the second half if the economy slows, so he has been putting more of his cash to work.

The best value in bonds today, Rodriguez believes, is in the two- to three-year maturity range, and in very long-term (15 years or longer) securities--not in the intermediate-term range.

For gutsy investors willing to bet that interest rates won’t rocket higher soon, a few other ideas:

* Muni bond funds staged a surprising comeback in the second quarter, posting positive total returns (though they still were negative for the half). The improved performance of munis may be due to a declining supply of new bonds, as states and cities issue fewer securities, while demand for high tax-free yields remains fairly strong.

* GNMA (mortgage) bond funds held up better than most categories in the second quarter and first half, despite derivative-security losses in some funds. A drop in mortgage refinancings is making this sector look and act better.

* The high yields (9% or better) on “junk” corporate bond funds minimized net losses for these funds in the half. Meanwhile, if the economy keeps improving, albeit more slowly, the finances of junk-bond companies also should improve, buttressing these bonds. “I think we still have more of a cyclical recovery to play in the bonds,” says Andrea Feingold, manager of the Colonial High Yield fund in Boston.

How Bond Funds Fared

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

Average total return Fund category 2nd qtr. 6 mos. 5 yrs. Money market +0.81% +1.5% +27.7% General muni bonds, long-term +0.62 -5.3 +41.8 Calif. muni bonds, long-term +0.29 -5.6 +40.5 High-quality corporate bonds, 1- to 5-year -0.35 -1.2 +40.6 Adjustable-rate mortgage bonds -0.61 -0.6 +31.6 Global money market -0.69 -2.8 +47.2 GNMA bonds -0.86 -3.3 +44.0 U.S. govt. bonds, 1- to 5-year -0.88 -2.1 +39.4 High-quality corporate bonds, 5- to 10-year -1.21 -3.9 +45.8 U.S. govt. bonds 5- to 10-year -1.27 -4.0 +42.1 Junk corporate bonds -1.31 -2.3 +59.3 High-quality corporate bonds, long-term -1.77 -5.1 +46.4 U.S. govt. bonds, long-term -1.79 -4.9 +42.7 Mixed bonds -1.81 -5.4 +47.4 Lower-quality corporate bonds, long-term -1.83 -5.1 +48.3 Global bonds, long-term -1.83 -6.9 +52.6

Source: Lipper Analytical Services Inc.