Bond Funds Are Likely to Become a Dicey Proposition This Year

Investors in bond mutual funds collected healthy returns in 1993, as falling interest rates for much of the year boosted the value of older bonds.

But for a taste of what might lie ahead, fund investors should focus on fourth-quarter results alone: A gradual rise in interest rates left many bond funds with net losses for the quarter. For that period, at least, money market funds would have been a better investment.

Despite the fourth-quarter turmoil, investors who sat in bond funds for all of ’93 earned total returns of between 6% and 20%, according to fund-tracker Lipper Analytical Services in New York. Those returns handily beat the 2.6% average 1993 return on U.S. money market funds.

Total return counts both the interest earned (the yield) and the appreciation or depreciation of a fund’s share price, which is a function of market interest rate moves. As rates fall, older, higher-yielding bonds are naturally worth more, which means fund investors’ shares rise in value.

Because market interest rates have been mostly falling since 1989, bond investors have enjoyed spectacular total returns in recent years, and especially in 1993:

* The average fund that owns long-term U.S. government bonds posted a total return of 9.3% last year--6.4% of which was yield, the rest price appreciation.

* Long-term corporate bond funds, especially high-yield junk bond funds, generally performed better than U.S. government bond funds. Corporates’ yields were higher, and the value of the bonds also appreciated more as market rates fell.

* Funds that own long-term tax-free municipal bonds also sported high 1993 returns, as last summer’s increase in federal income tax rates boosted demand for the bonds, adding to their price appreciation. The average long-term California muni fund had a total return of 12.6%, only 5.4% of which was yield.

But few Wall Streeters believe that those returns are likely to be repeated in 1994. If interest rates continue to creep up with the stronger economy, the price appreciation that boosted bonds in 1993 will turn into price depreciation .

The risk for bond fund investors--who now have $621 billion entrusted to the funds--is that market rates move up so much that price depreciation more than negates any yield earned this year.

Though fund owners by now ought to fully understand this risk, many experts worry that bond investors have been lulled into a false sense of security by five years of falling interest rates.

“I think there’s a great lack of perception that bond (fund) prices can decline,” says Glen King Parker, publisher of Income & Safety, a fund newsletter based in Fort Lauderdale, Fla.

Fourth-quarter fund results, as noted in the accompanying chart, should serve as an early warning. For example, the average total return on U.S. government bond funds in the quarter was a negative 0.36%: Though investors earned 1.6% in interest for the quarter (one-fourth of the 6.4% annualized yield on the typical fund), that was effectively wiped out because the share value of the funds fell nearly 2% in the quarter, on average.

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Of course, a fund pays out its yield regardless of fluctuations in share price. For buy-and-hold investors who simply need current income, it may not matter if higher interest rates send bond fund values lower this year.

Even so, there are steps that fund investors can take to lessen their risk of loss from an upward turn in interest rates this year:

* “Ladder” your portfolio. Investors who own long-term bond funds (which often own bonds maturing in 10 years or more) should spread some of that money into intermediate-term funds (which own five- to 10-year bonds) and shorter-term funds (which own one- to five-year bonds), says Michael Lipper, head of Lipper Analytical.

Intermediate-term and short-term bonds will drop less in value than long-term bonds if interest rates rise across the board, Lipper notes. Though you’ll earn a lower yield on shorter-term funds, you’re also lowering the risk of significant loss to your bond investment by diversifying among maturities.

Nearly all major fund companies offer funds of varying maturities, so diversification is easy.

* Consider corporate and muni bonds. Many investors own U.S. government funds for their perceived safety. But if interest rates continue to rise in an expanding economy, Treasury securities may depreciate far faster than corporate and muni bonds.

Why should corporate and muni bonds hold their value better than Treasuries? In the case of corporates, a stronger economy should bolster the finances of the companies behind the bonds. That makes high-yield corporate junk issues particularly attractive in 1994--at least for a portion of your bond investment--even after their stellar returns in 1993, says Income & Safety’s Parker.

Muni bonds, meanwhile, should benefit as high-income investors pour more of their assets into tax-free investments, to offset higher tax rates.

* Go with a general fund. Rather than hamstring yourself in a single bond category, ask your fund company if it offers a general fund--one that can mix Treasury, corporate and even foreign bonds. That will automatically give you greater diversification in what is certain to be a dicey market in 1994.

How Bond Funds Fared

Bond mutual fund owners enjoyed a third year of good returns in 1993. Bond yields were supplemented by share-prices appreciations as market interest rates fell.

1993 total returns for key bond fund categories:

Junk corporate: 19.3%

General bond: 12.9%

California muni: 12.6

U.S. government: 9.3%

Short-term corporate: 6.4%

Source: Lipper Analytical Services

Bond Fund Benchmarks

Here are average total returns for key categories of bond mutual funds for three periods ended Dec. 31. Total return includes interest earnings plus or minus any change in the bonds’ principal value. Included with each category name is a two-letter investment code for the group, which can be used to match year-end fund results published in last Sunday’s Times.

Average total return Fund cat. (inv. code) 4th qtr. 1993 5 yrs. Junk corporate (HC) +4.64% +19.3% +71.2% Global, +3.36 +17.0 +64.9 long-term (WB) General bonds (HC) +1.64 +12.9 +65.3 Calif. muni, +0.94 +12.6 +58.1 long-term (SS) General muni, +1.11 +12.4 +58.8 long-term (GM) Lower-quality corp., +0.25 +12.3 +68.4 long-term (AB) High-quality corp., -0.38 +11.2 +68.1 long-term (AB) High-quality corp., -0.12 +9.5 +63.1 5- to 10-year (IB) U.S. government, -0.36 +9.3 +61.8 long-term (GG) U.S. government, -0.17 +8.3 +57.1 5- to 10-year (IG) GNMA (GG) +0.34 +6.4 +61.4 High-quality corp., +0.56 +6.4 +51.2 1- to 5-year (SB) U.S. government, +0.25 +6.0 +51.8 1- to 5-year (SG) Global money market +1.26 +5.4 +41.9 Adjustable-rate +0.40 +3.8 +43.4 mortgage (FI) Money market +0.65 +2.6 +31.3

Source: Lipper Analytical Services Inc.