Switch from money-market to bond fund can increase yield--but beware of risks


With money-market-fund yields falling every week since December in reflection of the Federal Reserve's easier money policy, you may wonder whether the shrinkage of your dividend income could be abated if you switched to a bond fund that offers a higher yield.

Such a move could turn out to be the right thing to do. Before you make it, however, you need to bear in mind the risks involved.

Bond funds expose you primarily to two major risks: credit risk, the probability that issuers of bonds owned by the funds won't be able to pay interest or repay principal; and market risk, the probability that bond prices will fall when interest rates rise.

You avoid credit risk when you invest in a fund that buys only securities issued or guaranteed by the U.S. Treasury. You incur credit risk when you invest in a fund that also buys corporate bonds (or municipal bonds, in the case of a tax-exempt bond fund). The degree of risk depends on the creditworthiness of the bonds' issuers.

Market risk, however, can't be avoided when you invest in bond funds. It is greatest for funds concentrated in bonds having the longest maturities, even if they're backed by the full faith and credit of the U.S. government.

Under normal market conditions, you're offered higher yields for accepting greater credit or market risk. Whether they compensate you adequately is debatable.

Today's long-term interest rates are lower than they were a few months ago, but the reward for going long remains considerable.

Yields on long-term bonds -- Treasury, corporate, or state and local government -- are significantly higher than the yields on taxable or tax-exempt money-market securities. At about 8 percent, the recently sold 30-year Treasury bonds, for example, yield a lot more than the roughly 6 percent annual rate available from three-month Treasury bills.

If the Fed continues to relax its grip on the money supply to stimulate the economy, interest rates should continue to slip.

Under the circumstances, it's easy to see why you'd be tempted to go for a bond fund. You not only could be earning more money, you also might enjoy some capital appreciation inasmuch as bond -- and bond-fund -- prices rise when interest rates fall.

Eventually, however, conditions will change. The economy will resume its growth, interest rates will reverse themselves again, and bond prices will fall. Long-term bond funds would be likely to fall the most.

Since no one can predict when that will happen and assure you that you could switch back to your money-market fund before suffering a loss of principal, what should you be doing now?

You might want to consider switching to an intermediate-term bond fund -- one whose portfolio has an average weighted maturity of five to 10 years.

Intermediate-term bond funds typically provide higher yields than money-market funds. Though they involve greater market risk, they are not as volatile as long-term funds. Yet their yields are almost as high (and, at times, even higher).

There are an even 100 intermediate-term bond funds, according to Lipper Analytical Services. Sixty-five are taxable, divided into government and investment-grade funds, the latter being invested in various mixes of government and corporate securities. The other 35 are tax-exempt.

If you're in the 28 percent or 31 percent federal income-tax bracket, a municipal-bond fund might provide greater income than you'd have left after paying taxes on dividends from a

taxable fund.

Intermediate-term municipal-bond funds with superior long-run performance records include those offered by Vanguard, Dreyfus and Fidelity. Those funds offer annual rates of total return that have averaged 8 percent or more over the last five years.

Among no-load taxable funds, the five-year leaders had similar returns. Fidelity Government Securities, Benham Treasury Note and Prudential-Bache's Intermediate Term led the government category, and T. Rowe Price's New Income and Fidelity Intermediate Bond were pacesetters among investment-grade funds.

An alternative approach would be an index fund such as the Vanguard Bond Market Fund, which duplicates the bond market's ups and downs as measured by the Salomon Brothers Broad Investment Grade Bond Index. That index, which reflects the fluctuations of nearly 5,000 government, mortgage-backed and investment-grade corporate securities, has a weighted average maturity of 9.5 years.

If you're torn between governments and corporates, or skeptical about portfolio managers' abilities to sustain good performance records, an unmanaged index fund could be for you. By forgoing active portfolio management, you would, in effect, be letting the bond market manage your money.

Werner Renberg writes regularly on mutual funds for several publications, including Barron's, and has also written two books about mutual funds. Readers can write to him at 6 Sabina Road, Chappaqua, N.Y. 10514.

#1991, Werner Renberg

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