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Investigate bond funds that tout high yields


"Last fall, after selling our house and paying off two mortgages, we had about $50,000 to invest," a reader writes. "We had no investment experience [and] didn't want to get into high risk investments. After some research, we chose short and intermediate Treasury funds."

His choices: Janus Intermediate Government Securities fund, T. Rowe Price Adjustable Rate U.S. Government and U.S. Treasury Intermediate Funds, Scudder Short Term Bond Fund, and Vanguard Short-Term and Intermediate-Term U.S. Treasury Portfolios.

nTC "We chose dividend-paying funds," he adds, as "my wife had not yet begun receiving Social Security checks. While these funds all averaged between 6.6 percent and 5.5 percent annually, I realize now that they don't really appreciate.

"Can we improve our return without incurring greater risk?"

It is, of course, generally correct that higher returns require -- but aren't assured by -- taking higher risks. In his case, the answer depends partly on the funds he has in mind.

Consider his funds' recent records.

In the latest 12 months, their total returns ranged from Vanguard Intermediate-Term U.S. Treasury's 15 percent to T. Rowe Price Adjustable Rate U.S. Government's 2.1 percent.

The changes in net asset values ranged from the Vanguard fund's 7.9 percent gain to the Price fund's 3.2 percent loss.

In studying such funds, keep a few points in mind:

1. Bonds involve more than one kind of risk. When you own U.S. Treasury issues, for example, you don't have to worry about credit risk -- the risk that a bond issuer won't pay interest or repay principal. But you must worry about interest rate risk -- the risk that bond prices fall when interest rates rise.

3. Interest rate risk rises with the length of a bond's maturity.

4. Bond prices appreciate when interest rates fall; the potential for appreciation generally is greater for bonds of longer maturities.

5. Since definitions of "short term" and "intermediate term" vary, it's important to know the average maturity of a fund's portfolio.

6. Securities backed by mortgages involve the risk that homeowners accelerate principal payments when interest rates fall, causing income to slip as they're replaced by lower-yielding issues.

Against this background, you can understand why the Price and Vanguard funds that are concentrated in "plain vanilla" Treasury securities showed the greatest increases in NAVs and high returns.

But why would Vanguard's intermediate fund outperform Price's? In part because of a longer maturity. Vanguard's fund is managed to average from 5 to 10 years; on June 30 it was 6.8 years. Price's, however, must stay within a 3-to-7-year range; its latest reading: 3.9 years. An additional reason: Vanguard's expense ratio is 0.5 percent lower.

Both portfolio managers, Vanguard's Robert F. Auwaerter and Price's Charles P. Smith, have been shaving their average maturities.

The Janus fund, also concentrated in Treasuries, has done less well than its 4.4-year average maturity would suggest. That's largely because portfolio manager Ronald V. Speaker hedged the portfolio to keep its net asset value stable when he expected enactment of the Clinton stimulus package and, therefore, higher rates. When rates fell instead, the hedge hurt.

Portfolio manager Thomas M. Poor keeps only about one-third of the Scudder fund's assets in government-guaranteed and government-related issues. To achieve high income and net asset value stability, he stuffs the portfolio with a mix of other securities. They satisfy his credit quality criteria while providing higher yields.

The fall in interest rates and the extraordinary levels of mortgage prepayments caused the Price Adjustable Rate U.S. Government Fund, which invests primarily in government-related adjustable rate mortgage securities, to suffer principal and income erosion. To reduce its vulnerability, the fund has reduced its holdings of higher-yield securities that are characterized by higher prepayment rates.


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