This Time, It Pays To Be NearsightedJeffrey M. Laderman
When interest rates dropped in the mid-1980s, yield-hungry investors barreled into long-term U.S. government bond funds, only to suffer large losses when rates shot up in 1987. They then turned to "high-yield" bond funds. But the junk-bond market collapsed, big issuers defaulted, and the value of the funds plunged. Now, with bank interest rates at a 20-year low, people are pouring money into mutual funds that invest in shorter-term bonds. Will the crowd be wrong again?
Not likely. This time, bond-fund buyers are finally getting it right. In equity funds, it's best to invest for the long term. But in bond funds, shorter is better--whether it's corporate, government, municipal, or international. In fact, 27 of the 36 bond funds that won the top performance rating in the BUSINESS WEEK Mutual Fund Scoreboard are short- to intermediate-term funds (table, page 92 44 ). To help investors identify the best bond funds, we've expanded the annual Scoreboard to cover 555 funds, 100 more than last year.
"We're thankful that most of the new money has been coming into the short- and intermediate-term funds," says Ian MacKinnon, head of fixed-income investments for Vanguard Group. "Shareholders are not just trying to maximize yield. They can perceive the risks and act accordingly."
BALANCING ACT. Short-term bonds (and short-term bond funds) typically yield less than intermediate-term bonds, and both yield less than long-term funds. But yield doesn't tell the whole story. The longer the maturity of a bond--the time until the principal is returned by the issuer--the more sensitive the bond's price is to changes in interest rates. So determining the optimal fixed-income investment is weighing how much more risk you have to take for the extra yield.
Investors can't take all the credit for flying to shorter-term funds. They are responding partly to what mutual-fund companies promote. Says Avi Nachmany of Strategic Insight, a mutual-fund consulting firm: "These `low-volatility' funds have been designed for winning customers from depository institutions, and they've been very successful."
Not all short-term or "low-volatility" funds are alike. The funds get a lot more specific in their prospectuses. In general, most short-term funds keep their portfolio maturities below three years. Intermediate funds may stretch as high as 10 or 12. Beyond that, a bond fund is usually considered long-term.
Long-term yields look really tempting right now. Francis H. Trainer Jr., head of fixed-income investing at Sanford C. Bernstein & Co. and portfolio manager of the top-rated Bernstein Short Duration Plus Fund, says that most of the time, investors pick up only an additional 0.5 percentage points in moving from short- to intermediate-term securities, and another 0.5 percentage points for going long-term. A two-year Treasury note currently yields only 5%, and a 30-year bond, 7.8%. That's an unusually high difference between short- and long-term rates.
JUNK BUNK. But beware the long term. If interest rates go up one percentage point, the price of short-term bonds may be cut by 2%; the intermediates, 5%, but the long-term, 12%, offsetting 18 months of interest. Says Trainer: "The risks in long-term bonds are such that you might as well buy equities."
Of course, none of this mattered much in 1991, when interest rates fell. Bonds soared and bond funds scored the best total returns since 1985. The juiciest returns came from high-yield corporates, or junk-bond funds, up 38.7%. But that's only a rebound from several disastrous years. The longer-term returns tell the real story. A thousand dollars invested in the average junk fund at the start of 1989 would have grown to only $1,185 at the end of 1991. That's less than what the average money-market fund would have returned.
Morever, few junk-bond investors stuck around for the rebound. Consider the Dean Witter High Yield Securities Fund, which two years ago had about $1.1 billion in assets. In 1990, it posted an abysmal negative 40.1% total return, and shareholders left in droves. Despite a 67.2% bounceback in 1991, the fund now has only about $425 million in assets. New investors missed the revival, too. Only 8% of the the $78.4 billion invested in bond funds last year went to high-yield funds.
The junk-bond funds and the convertible bond funds, up 27%, drew their strength less from falling rates than from the buoyant stock market. Rising stock prices allowed junk-bond issuers to sell stock, improving the capitalization of the companies and bolstering their creditworthiness. Converts--bonds convertible into common stock--rose as prices for the underlying stocks soared. Junk and convertible funds can prosper as long as the stock market does, though a repeat of 1991's results doesn't seem likely.
But bond funds looked smart in 1991 even without the help of the stock market. Taxable funds, excluding high-yields and convertibles, racked up total returns of 14.4%. Because of the recession, the fixed-income market experienced a "flight to quality," and higher-quality corporate and Treasury bond funds fared best. Mortgage funds--those that invest in U.S. government-backed mortgage securities--fell behind in total returns even though the interest rates of those securities are, on average, about one percentage point higher than Treasuries of comparable maturities.
"That's about what you would expect when interest rates are falling," says Randall Merk, portfolio manager of the Benham GNMA Income Fund, one of six mortgage funds earning BW's highest rating, three up-arrows. Merk says the price performance of mortgage-backed securities is now sluggish because of a wave of refinancings. Once that passes--which he thinks will happen in the second quarter--the performance of mortgage funds should pick up. While over the longer haul mortgage funds have trailed long-term Treasuries, they are less volatile, too, since they carry average maturities of 7 to 10 years.
In fact, most government-bond funds--except those that specify they only invest in Treasuries--use mortgage-backed securities to enhance their returns. "We've sold virtually all our Treasuries," says Curt Hollingsworth, portfolio manager of the $2 billion top-performing Fidelity Spartan Limited Maturity Government Fund. "Now, we're all in Ginnie Maes because they offer the best value."
International bond funds haven't fared well in BW's ratings. While most concentrate their portfolios on shorter maturities to reduce interest-rate risk, they also face currency risk. This makes them volatile and hurts their ratings. For those who can take volatility, returns have been good. In 1990, international funds had a return of 14.4%, by far the best group performer that year. Although laggards in 1991, they still delivered 11%.
OFF THE MAP. One sort of long-term investment that has fared well in recent years is "high-yield" municipal funds. True, high-yield munis have longer maturities than their corporate cousins, but their credit quality is far better. They are not junk funds.
Take the T. Rowe Price Tax-Free High Yield Fund, with a three-year average annual return of 9.8%. It's really an investment-grade fund. Portfolio manager William Reynolds says the fund picks up higher returns by researching obscure corners of the muni market. "You have 60,000 to 80,000 issuers, and most are too small and sell bonds too infrequently to get ratings," he says. "That doesn't mean they're bad credits." Such bonds sport higher yields than those of better-known issuers.
Beyond maturities and credits, the critical factor in bond-fund returns are expenses. With the battle for yield so intense, every basis point--one one-hundredth of a percent--counts. Vanguard's funds do well, in part, because they're low-overhead, taking a mere 0.27 percent of assets annually. The average bond fund in the BW Mutual Fund Scoreboard spends 0.97 percent, or 97 cents for every $100. That may not sound like a lot, but every penny that isn't spent on expenses goes right to your pocket. Keep that in mind as you review the Scoreboard, which starts on page 93.
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