Bond funds an interesting alternative But beware of managers betting on interest rates


Gyrations in the stock market this year have persuaded many mutual fund investors to consider investment-grade bond funds as an alternative.

Other investors who hold a mix of stock and bond funds have seen the bull market in stocks throw their intended proportions of stocks and bonds out of balance, as stock values have climbed faster than those of bonds. They need to rebalance by adding bonds.

In either case, shopping for bond funds is daunting. But one thing you'll discover is that low-cost, index-based investing, which has outperformed active investing in equities for several years, works even better in bond funds.

Steven Lipper, a vice president at mutual fund data publisher Lipper Analytical Services, said the typical bond fund buyer has been someone who transferred money from money market funds or bank certificates of deposit into "junk" bond funds in quest of higher income. These investors may have little or no exposure to stocks or stock mutual funds.

Balancing a stock portfolio with high-grade bonds as a means of diversifying and reducing risk is a novel concept to many investors, he said. Even stranger is the concept of a bond index.

Nonetheless, professional investors and financial advisers for years have recommended a combination of stock and high-grade bond funds as a long-term strategy. Based on an upsurge in bond fund purchases in the spring, that message may be getting through to ordinary investors.

The fact that long-term government bonds outperformed small-company stocks from 1985 to 1995 helped make the case for high-grade bond funds.

And high-grade bonds are far more homogeneous than the stock market in risks and returns.

A successful high-grade bond fund is one that over many years beats the total return (income plus price appreciation) of a bond market index by 0.33 percentage point -- about enough to cover a low-cost fund's expenses. But expenses can range from 0.1 percent to more than 1.3 percent for essentially the same high-grade bond fund.

The lowest-cost bond funds are those that simulate a market index and expend few resources.

"The investment-grade bond area, with high-quality, highly liquid securities, is an ideal place for index investing," said Alice Lowenstein, bond editor at Chicago-based Morningstar research service. "There's very little a manager can do. There's no surer way to outperform [peers] among high-quality bond funds than to have smaller expenses. It doesn't make sense to go with a fund with above-average costs."

"Expenses are the biggest deal on the bond side," Lipper agreed. "The success of individual bond funds is more due to expense differentials than anything else."

Another distinction between bond and stock funds is that, for bonds, bigger is better. Critics have complained that many of the best-known actively managed stock funds have become too large, eroding flexibility and making it impossible for the fund to take meaningful positions in the most promising smaller stocks.

In high-grade bond funds, however, bigger funds command better prices, especially bidding for corporate bonds. There aren't any small-cap high-grade bonds. Bigger funds have greater opportunities to diversify across categories of investment-grade debt securities -- Treasury bonds, government agency bonds, mortgage bonds, corporate bonds. Bigger funds are better able to replicate bond market indexes.

Volpert said bigger funds also tend to have lower expense ratios, though he modestly admits that the statistics are skewed by the huge Vanguard bond funds that are among the cheapest in the industry.

Large funds that track a bond market index aren't necessarily fat and lazy. Lowenstein says many investment-grade bond funds try hard to beat their benchmark index returns, even by fractions of a percentage point, if only to cover their expenses. But investors should be wary of fund managers who bet on the long-term direction of interest rates -- for example, by extending the average maturity of the fund's bond portfolio in the hope that interest rates will fall.

One way to detect a manager making risky interest rate bets is to inspect the fund's investment return track record over several years. Funds reporting returns well above the market average and well below the market average in successive years should be avoided, she said.

Pub Date: 8/09/98

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