How To Get A Good Yield And A Decent Night's Sleep

For many people, searching for high yields has become an obsession. As rates on supersafe certificates of deposit and money-market funds wither away, investment risk, once anathema to conservative investors, is becoming more acceptable. That has enhanced the appeal of many existing bond funds and sparked mutual-fund houses to launch a spate of new investments. But investors need to examine fund holdings carefully to make sure they understand the risks as well as the rewards.

One new vehicle targeted at yield-conscious investors is the adjustable-rate mortgage fund. ARM funds yield about 7% to the average money fund's 5.25% and have minimal risk, since they invest primarily in pools of mortgages issued by government agencies such as the Federal National Mortgage Assn. They've also got downside protection: ARMs are reset periodically within prescribed ranges, so they won't follow fixed-rate mortgages all the way down if interest rates plunge. But since they have a ceiling, or cap, they will lag when interest rates spike up.

PIONEERS. Many investment professionals like the concept of ARM funds but note that they are untested. "They have yet to prove to be a really solid entrant in the yield sweepstakes," says Kurt Brouwer, president of Brouwer & Janachowski, a San Francisco-based investment firm. One concern is that the funds' popularity could lead to a shortage inthe supply of adjustable-rate mortgages, which would drive up prices on mortgage-backed securities and lessen fund yields. "It's not yeta problem, so ARMs are aviable alternative for people seeking yield," explainsJohn Rekenthaler, editor of Morningstar Mutual Funds.The introduction of no-load products is making ARM funds more attractive. Franklin's Adjustable U. S. Government Securities Fund, which launched the category, has a 4% load and total operating expenses of 0.84%. The newest entrants, such as Benham's Adjustable Rate Government Securities Fund and T. Rowe Price's Adjustable Rate U. S. Government Fund, don't levy sales charges. That can make a difference. If you pay a 4% load for 1% more in yield, it takes four years to break even.

The ARM fund's cousin, the Ginnie Mae fund, which invests in mortgages backed by the Government National Mortgage Assn., offers 8% yields and similar credit quality. But with Ginnies, the imbalance in supply and demand may already be a reality. The normal 1% to 1.5% yield gain of Ginnie Mae funds over 10-year Treasuries has shrunk to about 0.80% to 1% at best. If you have a long-term outlook, Ginnies may still be fine, but "over the next two to three years, there is the possibility for underperformance," says Rekenthaler.

Ginnie Mae funds are also more volatile than the shorter-term ARM funds. The average maturity of holdings in a Ginnie Mae fund is often about 10 years. In an ARM fund, it's closer to two years. And if mortgage rates continue to fall, an increasing number of homeowners may refinance, or prepay, to get a mortgage at a lower rate. That returns principal to the fund early, which must be invested at the lower rates and will depress the yield.

High-quality short- and intermediate-term bond funds are a low-risk alternative to money market funds. These funds try to beat the yields on comparable-length Treasury bonds while aiming for similar price stability. The government short-term (one- to five-year) bond fund group tracked by Lipper Analytical Securities had an average 12-month yield of 7.3% and a 12-month total return of 11.14%. Short-term bond funds that buy investment-grade corporate debt did almost as well. Intermediate funds, which hold securities with 5 to 10 years to maturity, have an average yield of 7.5% and a one-year total return of 13%.

ECLECTIC BACKING. High-quality short-term funds must have at least 65% of their assets in AA-rated bonds or better. For funds that invest in corporate bonds, that can include a wide mix of securities. Take Scudder's Short-Term Bond Fund, yielding 8.5%. Its holdings, which have no longer than three years to maturity, include asset-backed securities, collateralized mortgage obligations, and Mexican treasury bills, as well as U. S. government securities, corporate bonds, and Ginnie Maes. Fluctuations in a 2% range are the norm, says portfolio manager Tom Poor, who points out that even if the yield sank 2%, it would still beat a money fund.

Another type of fund vying for investor attention is the short-term multimarket fund. These funds invest in a mix of domestic and foreign CDs and government and corporate bonds. The aim is to yield at least two points more than U. S. short-term money market instruments. The oldest such fund, Alliance's Short-Term Multi-Market Trust, yields 8.71% and has a one-year total return of 10.81%. The bulk of its portfolio, which has an average maturity of 16 months, is in top-rated U. S. and Canadian government and bank securities.

But the hefty loads on multimarket funds take a 3%or so bite, and expenses can gnaw off another 1.5%. While the funds limit interest-rate risk by keeping maturities short, there is a currencyrisk. And trying to fathomthe hedging techniques the funds use to manipulate currency relationships is enough to send one scrambling back into the simplicity of money funds.

Municipal bonds are another place to look for higher yields. Because munis are exempt from federal and, often, state and local taxation, they return well above taxable investments with similar stated yields. With one-year munis yielding 4.35% and 15-year munis at 6.2%, "the penalty in yield for being short is substantial," says George Friedlander, managing director of fixed-income strategy for Smith Barney, Harris Upham. He says he is still buying insured bonds and those from water, sewer, and power agencies, which don't have the same budgetary headaches that state and local governments face.

BUDGET WOES. If you choose to lengthen maturities, however, don't sacrifice quality for yield. State and city budgetary woes are expected to be as severe as last year's, when quick-fix measures were used as stopgaps in the hopes that an economic recovery would materialize.

You can find higher yields on intermediate-term muni funds. Vanguard's Intermediate-Term Municipal Portfolio, with an average maturity of 9.1 years, grew from $1.4 billion in January to almost $2.2 billion as of September and is yielding about 6.1%. The company's high-yield municipal bond fund yields 6.65%.

As you move up the risk spectrum, it's hard to ignore the 12%-plus yields on junk-bond funds. The funds have been on a tear for about a year now, and some experts worry that the run is over. But just as many seem to feel there's more to go if the economy strengthens.

Not long ago, investors routinely found such juicy yields on CDs and other supersafe investments. But today, they're available only to those with a strong stomach for risk.

      SHORT AND INTERMEDIATE BOND FUNDS These investments buy bonds that have only 1
      to 5, or 5 to 10, years left to maturity. Some focus on Treasuries; others mix
      in corporate and mortgage-backed bonds. Yields hover at 7% to 8%. Credit risk
      on high-quality funds is low
      ADJUSTABLE-RATE MORTGAGE FUNDS ARM funds invest primarily in mortgage-backed
      government securities with rates that are reset periodically. The funds, which
      yield about 7%, are a cross between stable money-market funds and
      higher-yielding short-term bond funds. Dwindling ARM supply may depress yields
      GNMA FUNDS "Ginnie Mae" funds invest in fixed-rate mortgage bonds issued by
      the Government National Mortgage Assn. The huge inflows into these funds mean
      that investors may pay fairly rich prices. Prepayment of mortgages may lower
      stated 8% yields
      JUNK FUNDS These risky funds fill portfolios with below-investment-grade
      securities. They yield about 12%, but a high default rate among their portfolio
      of debt-ridden companies may deflate that number. Also, fund prices may be near
      a peak
      DATA: BW
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