Bonds: These Waters Only Look Calm

No doubt about it--U.S. government bonds are looking good these days. With inflation quiescent, the 30-year Treasury bond is at just 5.7%, near its historic low. Many market mavens expect long bond rates to fall to 5% or below, producing tidy capital gains.

But if you think bonds are a safe haven against economic troubles in Asia or a downturn in the stock market in the U.S., you may be in for a surprise, according to a recent report by Leah Modigliani, an investment strategist at Morgan Stanley Dean Witter. In the past 20-year period, volatility in long-term U.S. government debt has steadily increased because of high inflation (chart). Bond volatility even surpassed that of the Standard & Poor's 500-stock index for the 20-year periods ended in 1996 and '97.

This is of particular concern if you're thinking of buying a long-term bond fund to diversify your portfolio and gain maximum yield. Many investors regard long-term bond funds as parking places for cash--even if the investment horizon is just one year. Morningstar estimates that long-term funds returned 7.5% over the five years ended on June 30, compared with 6.2% for intermediate funds. But the long-term funds were 38% more volatile. "If you're an investor with a one-year outlook, some long-term bond funds are much more volatile and risky than you might think," says Modigliani.

SHARPE SHOOTING. Volatility isn't necessarily bad, as long as you're compensated for the risk you take. But how do you assess the risks in bonds? One way to get risk-adjusted returns is to look at a fund's Sharpe Ratio, a commonly used measure of risk-adjusted returns. You want a high Sharpe Ratio because it denotes a higher risk-adjusted return. Unfortunately, the Sharpe Ratio is difficult to interpret. So, Modigliani and her grandfather, Franco Modigliani, finance professor at Massachusetts Institute of Technology and Nobel laureate, developed another measure of risk-adjusted performance. Called Modigliani-Modigliani, or M2, it is a return adjusted for volatility that is measured in basis points and allows for a comparison of returns between portfolios.

M2's aim is to be more precise than the risk-adjusted performance ratings used by Morningstar or BUSINESS WEEK but easier to understand than a Sharpe Ratio. Nonetheless, funds with the highest Sharpe Ratios have the highest M2 and vice versa.

We asked Modigliani to put M2 to work on long bond funds with the highest total returns over the past five years, as measured by Morningstar's Principia database (table). The one with the best total return, before adjusting for risk, was American Century-Benham Target Maturities Trust 2020. It became the second-best performer on a risk-adjusted basis. But look at the risks the fund takes. American Century-Benham achieved its results with four times more volatility than the Lehman Brothers Government Bond Index and three times more than the best risk-adjusted performer, Wasatch-Hoisington U.S. Treasury.

A brief look at the funds' portfolios explains why American Century-Benham is one of the riskiest long-term bond funds. The fund invests in zero-coupon U.S. Treasury securities and U.S. Treasury bills, notes, and bonds that will mature in 2020. This gives it an extremely long duration, a measure of how sensitive a bond's price is to a move in interest rates. The longer the duration, the more the price will be affected by a change in interest rates and, thus, the more volatile the fund. For example, when interest rates went up in the first quarter of 1996, the average long-term government bond fund lost 5.6%. But American Century-Benham fell a steep 16.6%, according to Morningstar.

Right now, however, American Century-Benham's long duration is a plus because long-term rates have been falling. In the past year, the fund is up 61%, putting it in the top third of the entire mutual-fund universe--debt and equity.

RIDING THE CURVE. Another fund benefiting from a long duration is Wasatch-Hoisington U.S. Treasury, which produced its returns with a lot less risk. It was up 21.4% in the past 12 months with a volatility measure of 5.8, vs. 20.3 for American Century-Benham. Unlike the American Century-Benham management team, Wasatch- Hoisington co-manager V.R. Hoisington can invest in any maturity of U.S. Treasury, from six months to 30-year zeros. Since June, 1996, Hoisington has been 100% in long bonds with maturities of 26 to 30 years. "As long as inflation continues to head down and monetary policy remains as it is, we see little risk in the long bond," says Hoisington. How does he manage risk? He doesn't. Hoisington says he doesn't try to damp the volatility of his fund by hedging. "Any low risk we've had has been circumstantial," he says.

Another top risk-adjusted performer, Pacific Advisors Government Securities A (up 19.7% in the past 12 months), actively manages risk, however. Its risk-adjusted 7.1% return came with four times less volatility than American Century-Benham's. Pacific Advisors is a total-return bond fund that uses a proprietary interest-rate timing model to bet on the direction of rates. "We try to navigate the yield curve to figure out where we can get the most money for the least risk at any point in time," says Marc Kelly, co-manager of the $4.5 million fund. Kelly shortens the fund's duration when he thinks rates will rise and lengthens when he thinks they will fall. Now, he's buying bonds with an average maturity of 26 years because he sees rates heading lower.

The fund's success in managing duration helps explain why this fund has the lowest standard deviation--a measure of how much its returns vary from its long-term average--among the group of top performers. But there's another reason Pacific Advisors has done well. Kelly is permitted to invest up to 35% of the fund in the stocks of domestic and foreign utilities that have good fundamentals--and above-average dividends that have been growing. About 16.5% of Kelly's fund is in such utilities as CMS Energy, Ipalco Enterprises, and Nipsco Industries. The average yield of his domestic stock holdings is 3.3%, vs. 1.5% for the S&P 500.

EXTRA POINTS. The T. Rowe Price U.S. Treasury Long-Term and Vanguard Fixed Income Long-Term U.S. Treasury funds are other solid performers on a risk-adjusted basis--up 19.2% and 18.4%, respectively, in the past 12 months. Both are managed similarly, giving them comparable volatility and risk-adjusted returns. Neither manages duration, and their volatility is nearly twice that of the Lehman Brothers Index. But they do try to add value through yield enhancement. T. Rowe Price Manager Peter Van Dyke has invested 15% of the fund in Ginnie Mae-backed long collateralized mortgage obligations. These give him 60 to 80 extra basis points of yield over the long bonds. Van Dyke and Robert Auwaerter, manager of the Vanguard Fund, avoid buying the newest 30-year Treasuries; their yields tend to run about six to eight basis points less than more seasoned bonds because new paper is in strong demand. Like many of his bullish peers, Auwaerter is buying Treasuries with maturities of 26 to 28 years.

When you're looking at bond funds, it's critical to look beyond their total returns. M2 isn't in wide use yet, but you can get hold of Sharpe ratios and volatility measurements for funds from Morningstar, Value Line, and many fund groups themselves. Use the tools to make sure you're paid for the risks you're about to take.

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