Mutual Funds: THIRD-QUARTER REVIEW FOR INVESTORS : BOND FUNDS : For the Disillusioned Investor, Few Places to Hide

Bond mutual fund owners got no respite in the third quarter: Market interest rates kept rising with the growing economy, and the result is that most bond funds are deeper in the hole for 1994 than most stock funds.

Lipper Analytical Services’ calculation of the average total return on fixed-income funds this year is a negative 3%. That means that even after counting interest earned for the last nine months, the typical bond fund owner’s $100 investment on Jan. 1 is worth $97 now.

In contrast, the average general stock fund is down 0.5% this year.

The problem for bond investors this year has been a lack of places to hide. In the stock market, some categories of equities are usually rising while others are falling. But for bonds, when market interest rates rise, all bonds tend to depreciate, though at different speeds.

Investors who have stuck with long-term bond funds this year have seen their principal hammered hardest, because prices of those bonds crumble fastest as market yields rise.

That’s because no one wants to buy, say, a 6% bond that matures in 20 years when new 20-year bonds are paying 7%. The market slashes the price of the 6% bond to artificially make the yield competitive with new bonds.

For shorter-term securities, however, depreciation isn’t as severe, even when interest rates rise as rapidly as on longer-term bonds. The faster a bond matures, the less fearful investors are of holding it.

Thus, the Fidelity Short-Term Bond fund is down just 2.0% so far this year in total return, while the Fidelity Government Securities bond fund, which owns longer-term issues, has dropped 5.4%.

Compounding the problem is that certain so-called derivative securities in some bond funds have blown up, deepening losses. Often, derivatives were used to make leveraged bets on interest rate trends; fund managers who guessed wrong paid a heavy price.

Or rather, their shareholders did.

The only question any suffering bond investor cares about now is: Will interest rates stop rising soon?

There are still optimists, though it’s worth noting that many of them also thought rates were finished rising in June.

Instead, the 30-year Treasury bond yield is at a 27-month high of 7.81% now compared to 7.61% at the end of June and 6.35% on Jan. 1.

Bond bulls’ classic error this year has been to underestimate both the economy’s strength and the Federal Reserve Board’s resolve to rein in that strength by driving rates up.

But at some point, bond yields should reach levels that prove irresistible to investors, bringing buyers in and starting the process of pushing rates down, or at least stabilizing them.

Scott Grannis, economist at $12-billion Western Asset Management in Pasadena, believes long-term yields are indeed in the process of peaking after one of the most dramatic bond selloffs in history.

“It’s hard to say this is the absolute top, but we think it has gone about far enough,” he says.

But bond market bears say such arguments are nonsensical. Interest rates are nowhere near their peaks, the bears say, because the global economy is nowhere near its peak of growth in this cycle.

Kurt Brouwer, whose firm Brouwer & Janachowski in San Francisco directs mutual fund investments for individuals, believes that U.S. interest rates are in a new rising cycle, after a 13-year declining cycle. This is no time to own very long-term bonds, he says.

With the jump in short-term yields this year, Brouwer notes, “There are plenty of things you can do now if you need your money producing at least a 5% return.” One-year Treasury bills, for example, yield 5.9%; a two-year T-note pays 6.6%.

Given that level of virtually risk-free return, it’s just not worth the principal risk of buying longer-term issues for an extra point or two in interest, Brouwer says.