Time for a Reality Check on Bond Funds

Times Staff Writer

The recent rebound in interest rates is reminding investors that it's possible to lose money in bonds -- the "safe" securities that have roared into favor with millions of Americans over the last three years.

For those who own bond mutual funds, it's time for a reality check and a portfolio check, financial advisors say.

Yields on longer-term U.S. Treasury securities surged last week to their highest levels since at least early January, propelled by early optimism about the progress of the war in Iraq. The annualized yield on the five-year T-note, for example ended Friday at 3.08%. It has rocketed from a four-decade low of 2.48% reached March 10.

The jump in market yields has meant red ink for many bond mutual fund owners in the last two weeks. As yields available on new bonds rise, older fixed-rate bonds decline in value. That is why share prices of many bond funds have been falling.

The net asset value per share of the Pimco Total Return bond fund, the nation's largest, was $10.67 on Friday. The share price lost 1.1% for the week and is down nearly 1.7% since March 10.

Bond investors can make money two ways. One is through interest income generated by the securities -- the main reason for owning bonds. The second is through capital appreciation, which generally occurs when market interest rates are falling, making older bonds issued at higher yields more valuable.

Because the trend in interest rates has been down since mid-2000, bond investors have reaped generous "total returns" -- that is, interest earned plus principal appreciation.

The average total return of mutual funds that own long-term government securities was 9.9% last year, according to fund tracker Lipper Inc. The return averaged 9.3% a year from 2000 through 2002, while the stock market slumped all three years.

No wonder investors poured a record $140 billion in net new cash into bond funds last year, according to the Investment Company Institute, the funds' chief trade group. By contrast, stock mutual funds had a net cash outflow of $27 billion.

Despite the share price declines of the last two weeks, many bond funds still show positive total returns year to date. Pimco Total Return is up 0.6%, for example. The Schwab Total Bond Market fund is up 0.3%.

But if interest rates were to continue rising, bond funds' total returns would shrink further, and could turn negative. Investors still would be earning interest, but the decline in their bonds' principal value would offset that income.

If market rates rose fast enough, principal depreciation effectively could more than wipe out interest earned.

That's what happened in 1994, when interest rates soared as the Federal Reserve tightened credit. The average long-term government bond fund had a total return of negative 4.6% that year, according to Lipper.

Bond market pros say it's important for investors to understand the risk in the securities. But many also caution against overreaction.

Even if the war goes well for the United States, leading to a stronger economy, bond yields are unlikely to continue rising at the pace of the last two weeks, most experts say. They say the recent rebound reflects that Treasury yields, in particular, had fallen to unrealistic levels.

"This isn't 1994. We aren't going to 8% on the 30-year Treasury bond," said Jack Malvey, chief fixed-income strategist at brokerage Lehman Bros. in New York. The 30-year T-bond yield was 5.03% on Friday.

The Federal Reserve, which controls short-term interest rates, isn't expected to raise its benchmark rate from the current 1.25% anytime soon. As long as the Fed stands pat, it exerts a strong restraining force on other interest rates, though that is more true of shorter-term rates than longer-term ones.

Some money managers say hopes for a healthier economy may be premature. If they're right, interest rates could start falling again.

The 10-year Treasury note yield, a benchmark for mortgage rates, was 4.10% on Friday. "You might see 3.5% before you see 4.5%" on the 10-year T-note, said Ken Anderson, who helps manage $65 billion in fixed-income assets at Evergreen Investment Management Co. in Charlotte, N.C. "I don't feel that there's a huge sell-off risk in bonds at this point."

Others say investors should be positioning themselves for a better economy that could put upward pressure on inflation in the next few years. Inflation is bond owners' greatest enemy because it erodes the fixed interest returns of the securities.

"I think the long-term trade now is to buy stocks and sell Treasuries," said Richard Nash, chief market strategist at Victory Capital Management in Cleveland. He expects the yield on the 10-year T-note to be around 5% a year from now.

Whatever their outlook, bond investors should take inventory of what they own and how their securities could be affected by changing market rates, financial advisors say.

Here are some points to consider:

* Even if interest rates have bottomed and move higher in the next year or so, bond owners' loss of principal value won't come close to what many stock investors have lost since 2000. And with interest still coming in regardless of fluctuating principal values, the worst-case scenario for bonds might be negative total returns in single digits.

In 1999, when the yield on the 10-year T-note rose from 4.6% at the start of the year to 6.4% at year's end, the total return on the Fidelity Government Income fund was negative 2.3%.

* Different types of bonds may react differently to market interest rate shifts. In general, the principal values of shorter-term bonds are less vulnerable to rising rates than are those of longer-term bonds.

That makes sense, because being stuck with a inferior-yielding bond for, say, two years isn't as bad as being stuck for 10 years.

Year to date, the total return of the Vanguard Short-Term Treasury bond fund is negative 0.1% compared with the negative 1.3% return of the Vanguard Long-Term Treasury fund.

Also, what is bad for Treasury bonds and other high-quality securities may be good for other bonds: Prospects for an improving economy have driven yields on corporate junk bonds to three-year lows in recent weeks even as Treasury yields have jumped.

The Pioneer High-Yield bond fund, which owns junk securities (non-investment grade issues), is up nearly 8% this year in total return.

* Step back and ask yourself why you bought bonds to begin with. If you own them for basic portfolio diversification, there may be no good reason to sell even if interest rates may be headed higher, experts say.

Also, though bond mutual fund owners may see their share values suffer in times of rising rates, there can be an upside: As bonds in the portfolios mature or are sold, they would be replaced by securities paying higher yields, boosting shareholders' interest earnings over time.

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