Nervous investors turning to bond funds Falling interest rates help bond performance


The stock market is still flying high, so some nervous investors are moving some money back into bond funds, while still putting the bulk of their cash into stocks.

For the first three months of 1998, bond funds added $21.8 billion in net new cash, compared with $28.94 billion for all of 1997 and only $2.76 billion in 1996.

In the past 12 months, investors have gotten some pretty good performance, at least by bond fund historical standards. A number of bond fund categories have had returns at what had been the historic averages for stock funds -- about 10.7 percent annually.

At the same time, and for the first time, stocks produced returns of over 20 percent for three consecutive years and seem to be headed there again this year.

"In general, people who are worried about the market are going into bond funds now," said Kevin McClintock, head of fixed income for Dreyfus Corp. in New York. "Many investors are going into high-yield bond funds for the higher return. I view those as either risky bond funds or very conservative equity funds," he said, because the junk bond funds tend to reflect market performance.

Part of the reason for good bond fund performance has been falling interest rates -- down more than a half percent, a large drop for bonds -- from last year. But they have bounced back somewhat, from 5.7 percent in January to closer to 6 percent now. As a percentage, however, those small movements in rates loom large because as interest rates fall, the prices of higher-rate older bonds rises.

Tightening supply, even with the same demand, also may keep bond prices up. As the booming economy continues to lead to a budget surplus, the Treasury Department plans to issue fewer bonds.

This month, the Treasury Department said that it expected borrowing between July and September to be around $5 billion. Borrowing in the first quarter was $27.6 billion.

"The Treasury bill market has been reduced for a while, and whenever there is less supply and the same or more demand, it puts a squeeze on the bond market," said Coleen Denzler, who manages three municipal bond funds for American Century Investments in Mountain View, Calif.

Denzler said a supply crunch, if one develops, may lead to more bonds being issued by municipalities and corporations. Or the Japanese central bank, a huge owner of U.S. Treasury bonds, may decide to dump some to meet its needs, increasing supply. Most asset allocation models call for investors to keep some money in bonds or bond funds to diversify their portfolio.

But it is important to keep in mind that bond funds are not bonds. The reasons you buy bonds -- fixed maturity, fixed income and guaranteed return of principal (barring the rare default) -- are all absent from a bond fund.

The funds, being pools of bonds of varying maturities, which are constantly traded, have no fixed maturity, no fixed interest, and, as bond fund holders found to their dismay in 1987 and again in 1994 when interest rates rose and bond prices fell, no guaranteed return of principal. Fund industry expert Michael Lipper has described owning a bond fund as owning stock in a company that owned a portfolio of bonds.

What the funds do offer is regular reinvestable income, professional management, liquidity -- which makes it a lot easier to sell a bond fund than a bond -- and the possibility of higher total return on the fund than you might get on an individual bond.

Many financial planners suggest "laddering" bonds -- owning bonds that mature in successive years, so you constantly reinvest the principal as the bonds come due. That allows you to keep current with the market.

But here bond funds may be a less costly alternative for those who can't afford to pay $1,000 to $10,000 at a shot to buy bonds or Treasury bills. Just be sure to buy a bond fund with the lowest possible expenses, because they can cut the total return heavily.

So the question arises: Do you need bond funds in your portfolio? That may depend on why you're investing.

If your asset allocation is designed for retirement planning, and you have a defined benefit pension that will pay you a fixed amount of cash monthly, you may consider the pension as the fixed-income portion of your portfolio.

Having that income cushion means it may be easier to take some more risk to keep pace with inflation long term.

Pub Date: 5/24/98

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