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As rates fall, long-term funds offer better chance of keeping dividends flowing


As your money market fund's yield plunged during the last couple of years, you probably read and heard that you should switch some (or more) of your portfolio to bond funds to lift your income.

Such advice commonly made three points:

* Yields are normally higher for long-term than for short-term securities to compensate investors for accepting inflation risk, which is assumed to grow with time. (How much higher the yields may be depends on supply-demand balances for various types of bonds at each maturity level.)

Thus, bond funds with long average maturities could be expected to provide significantly more income than those whose securities mature within two or three years, or than money market fund portfolios whose average maturities run only about two months or less.

* Funds primarily invested in longer maturities, however, involve more interest rate risk -- the risk that prices would fall when interest rates rise -- than those concentrated in shorter securities.

While long-term funds can be suitable for those who have a long investment horizon and can tolerate their riskiness, intermediate-term funds were often recommended instead. They would fall less, you may have been told, but they would yield almost as much.

* If interest rates should continue to fall, prices of bonds and of bond funds would rise, enhancing their total return. Those of long-term bonds and funds would rise more than the others.

Another point should have been made but may not have been: When rates fall, long-term funds come closer to maintaining their streams of dividend payments than short-term funds, whose portfolios turn over more frequently and, therefore, absorb sooner the newly issued securities bearing lower interest coupons.

For investors who have to take dividends in cash because they need the money, this is an especially important consideration.

If you invested in a long-term fund, you're probably glad that you did.

But if you have not and believe you could be comfortable with the inherent risk, you may still wish to consider one, even if you've already missed a good share of the rewards that have been available for extending maturities during the recent stage of the market cycle.

To appreciate how durable the dividend stream of long-term funds can be, look at the accompanying table. It provides data calculated by The Vanguard Group for hypothetical $5,000 investments in its short-term and long-term corporate and municipal bond funds and its intermediate-term muni fund. (Vanguard doesn't offer an intermediate-term corporate fund; its intermediate-term U.S. Treasury fund is less than a year old.)

Even though Vanguard's money market funds have been among the best performers (as have its bond funds) -- in part because of its low expense ratios -- dividends paid by its taxable and tax-exempt funds plunged by about 35 percent and 20 percent, respectively, in the latest 12 months.

It was the cost you had to pay for staying with the safety of money market funds -- because of necessity, low risk tolerance or indecision -- at a time when the Federal Reserve Board was vigorously cutting short-term interest rates to stimulate the economy.

If you had switched from either money market fund to the corresponding short-term fund on July 31, 1990 -- just before Iraq's invasion of Kuwait and the start of the recession -- you would have received more income in the first year and your income would have dropped less in the second.

For accepting a slight interest rate risk -- the corporate fund is expected to have an average maturity of less than three years, the municipal fund of less than two -- you also would have had the added pleasure of a modest increase in your fund's net asset value (NAV).

But the real rewards would have been found in going long.

The Investment Grade Corporate Portfolio (roughly 80 percent corporates, 20 percent governments), whose average maturity is expected to range between 15 and 25 years, has stayed around 20.

Because long-term interest rates have remained fairly stable -- in sharp contrast with money market rates -- its income payments fell only about 4 percent in the latest year. Also helpful: Portfolio manager Paul G. Sullivan of Wellington Management Co. has tried to minimize his holdings of corporates that could be called and would have to be replaced with lower-yield bonds.

If the yield -- that is, dividends paid in the latest 12 months divided by the latest NAV -- fell more steeply in going from 8.8 percent to 7.7 percent, it's due more to an 11 percent increase in the NAV.

The story was even better for shareholders depending on the Long-Term Municipal Portfolio (average maturity: 16 years) for income. Its payments in the latest year were virtually the same as those for the previous year. The drop in its yield, from 6.8 percent to 6.3 percent, was essentially due to a 7 percent rise in its NAV.

Whether a Vanguard or another firm's long-term bond fund may be appropriate for you depends on how you balance all the possible risks with the rewards. But, reflecting on all these figures, you realize how much you risk dividend instability by emphasizing NAV stability.

"Far too few shareholders appreciate dividend stability," says Jerome J. Jacobs, a Vanguard fixed-income group vice president.

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