Bond Funds: Safe Again For A Short Term Ride

In 1994, many short-term bond fund investors had a rude awakening. They thought they had parked their money in a relatively safe place. So they were shocked to see funds fall as much as 10% because managers had bet heavily on risky derivatives at a time when interest rates were shooting up. Furious holders of PaineWebber's Low Duration U.S. Government Income Fund--down more than 4%--sued, prompting the firm to infuse $33 million into the fund and change the manager.

Since then, short-term bond funds have regrouped and cleaned up their portfolios. Now, once again, they're being lauded as a good hedge against the overheated stock market as well as a nice spot to stash cash. "There's an excellent risk-return trade-off," says William Gross, who manages $6 billion in short-term bond investments, including the $2.6 billion PIMCo Low Duration Fund, for Pacific Investment Management, based in Newport Beach, Calif. "The shorter you are, the more protected you are."

QUICKLY REINVESTED. Short-term bond funds, which invest in government and corporate bonds with maturities of one year to three years, bill themselves as offering better returns than money markets and less exposure to interest-rate fluctuations than longer-term bond funds. When interest rates rise, hurting bonds generally, short-term debt comes due sooner and can be quickly reinvested at higher rates. In addition, the generally high credit quality of short-term bonds means there's little chance of default.

Over time, that's a winning combination, says Morningstar analyst Mark Wright. He points out that after fees, short-term taxable bond funds have returned--pretax--an average of 6% annually over the past five years, compared with 4% for three-month Treasury bills, a typical component of money-market funds. Over 10 years, the gap widens to more than 9% for short-term bond funds and 5.5% for three-month T-bills. Tax-free short-term bond funds have returned 5.4% for the five-year period and 5.6% for the 10 years.

Investors heavily into equities should consider this group for balance, says Brad Tank, manager of Strong Short-Term Bond Fund. He has found that over the past 75 years, portfolios of 80% equities and 20% short-term bonds have had better returns without any more volatility than those with 80% stocks, 20% cash.

Buyers should remember, however, that short-term bond funds don't guarantee full return of principal as money market funds do. Anyone considering this group should first examine costs. Wright says short-term bond funds return fairly similar numbers over time, regardless of management, so don't pay exorbitant fees. Look for expense ratios in a fund's annual report. Around 0.5% to 0.6% is reasonable; 1% is harder to justify.

You must also consider the time frame of the fund. Ultrashort funds restrict themselves to one-year investments, making them more conservative than those with a three-year horizon. Match the fund to your needs. People saving for a home they expect to buy in three years can go out longer than those who need money to pay tuition next year.

Most important, check the holdings, says Joan Payden, president of Los Angeles bond investment adviser Payden & Rygel, which offers its own short-term fund. The top performer of the past three years, Sit U.S. Government Securities, keeps 66% of its portfolio in mobile-home bonds, which tend to provide a stable income stream.

On the other hand, managers who invest in international bonds are prone to interest-rate and currency risk. Also beware of bonds from developing countries or unknown companies, which can be iffy. And look out for securities from the Federal Home Loan Bank and Federal National Mortgage Assn., which may be derivative instruments. (All holdings are listed in the fund's semi-annual reports.)

PUMPED-UP RETURNS. For investors with a higher risk tolerance, Sandy Rufenacht of the Janus Short Term Bond Fund uses junk bonds to pump up returns and smooth out volatility in the Treasury market. All investors should make sure the fund's derivative position isn't a bet on interest-rate direction. If you have questions about any derivatives you spot, call the portfolio manager for an explanation. Rating groups, such as Morningstar and Value Line, also provide a risk analysis of each fund.

Performance during historical bear markets is another benchmark. But recent results matter, too. "If a fund's yield is significantly higher than average, get the six-month report and see what investments are in there," Payden advises. While short-term bond funds promise a better reward than money markets, investors interested in avoiding another 1994 should be sure the risks are in check.

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