Taking Stock of Bond Funds and Looking Ahead
Under the assumption that it helps to talk about it when misfortune strikes your life, here’s what 1994 was like for millions of bond mutual fund owners:
* Government and corporate bond funds posted a negative “total return†of 3.3% on average, as a plunge in bond principal values more than offset the funds’ interest earnings for the year, according to fund tracker Lipper Analytical Services.
That loss--the first calendar-year decline for bond funds since 1974--means the typical fund share owner who had $1,000 invested a year ago now has $967.
* Intermediate-term bond funds--which mostly own bonds maturing in five to 10 years--posted surprising losses equal to about 80% of the losses on longer-term bond funds. The intermediate-term funds had been viewed as a safe haven for investors who wanted a decent yield with low risk, but that assumption proved devastatingly wrong.
* Tax-exempt municipal bond funds posted the worst losses of major fund categories, with general long-term muni funds off 6.5% on average. And to add insult to injury for California muni fund owners, funds that own privately insured California bonds actually performed worse than those that own uninsured bonds--a loss of 8.5% versus 7.5%, respectively, for the year.
* Only 25 bond funds of 3,233 tracked by Lipper had positive returns in 1994. For most yield-oriented investors, the only smart place to be was in money market funds, which keep most of their assets in securities maturing in 90 days or less. Money funds’ average return in ‘94: 3.7%.
* By year’s end, some unhappy bond fund investors were questioning the logic of owning bond funds at all, versus simply buying U.S. Treasury securities directly and holding them to maturity--a guarantee against any principal loss.
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Bond funds’ tragic year, of course, was a result of the dramatic surge in market interest rates, as the Federal Reserve Board tightened credit for the first time since 1989. Rising rates devalue older bonds issued at lower rates, and the further a bond is from maturity, the greater the decline in its value as newer bonds offer higher yields.
Certain categories of bonds also suffered their own particular problems in 1994. Municipal bonds, for example, tend to decline faster in value when rates rise, simply because the muni market is very illiquid--meaning the bond issues tend to be small and don’t trade much. What’s more, Orange County’s bankruptcy in December set off a huge selling wave by nervous muni investors nationwide, driving bond values even lower.
Still, perspective is useful at a time like this. The fund industry can argue that one loss in 20 years isn’t so bad. And investors who have owned bond funds through the first half of the 1990s (i.e., since Dec. 31, 1989) have generally earned much more than they would have in a money market fund, even including last year’s losses. The average long-term U.S. government bond fund’s five-year total return is 37.4%, compared to 25.2% for money funds, according to Lipper.
Even so, the burning question for many bond fund shareholders as 1995 begins is whether the fund concept has outlived its usefulness. If you want income, one argument goes, just buy U.S. Treasury securities directly and hold them to maturity. With two-year Treasury notes now yielding 7.65% annually and five-year T-notes yielding 7.86%, you can earn a healthy return and be guaranteed that you’ll get all your money back at maturity--a claim that bond funds can’t make.
Indeed, a major problem the funds now face is that shareholder redemptions continue at a brisk pace. If that goes on in ‘95, many fund managers will be in the painful situation of selling bonds and taking losses, even if intermediate- and long-term interest rates finally stabilize.
Even happy bond fund owners have to realize that “they’re at the mercy of their fellow shareholders†with regard to redemptions that shrink the funds, says Catherine Voss Sanders, analyst at fund rater Morningstar Inc. in Chicago. And while investors who want corporate or muni bonds may still find it far more comfortable to own diversified funds than risky individual securities (remember Orange County), there is no such risk in owning Treasury securities direct, Voss Sanders notes.
But Ian MacKinnon, head of Vanguard Group’s bond funds, argues that when people start talking about the fund concept’s demise, historically “that has precisely been the time to buy.†He believes that long-term bond yields already reflect the expectation of further Fed hikes in short-term rates this year to slow the economy. If long yields stay basically stable, those fund owners will earn 6% to 8% this year in interest; if the economy slows enough, long rates may fall--giving fund owners a capital gain as well.
The trend of interest rates is anybody’s guess, of course. But Lipper Analytical’s Michael Lipper says the big lesson from 1994 is that “whenever everyone flocks to one area, that’s where you’re going to have trouble.†In 1994, that was intermediate-term bonds, relatively speaking. In 1995, Lipper warns that if the Fed keeps pushing up short rates, the disaster may be in bonds in the one- to two-year range--the securities so many risk-averse investors are now clamoring for.
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How Bond Funds Fared
Here are average total returns for key categories of bond mutual funds for three periods ended Dec. 31. Total return includes interest earnings plus or minus any change in the bonds’ principal value.
Average total return Fund category 4th qtr. 1994 5 yrs. Money market +1.16% +3.7% +25.2% High-quality corporate bonds, 1- to 5-year -0.10 -0.4 +36.3 U.S. govt. bonds, 1- to 5-year -0.11 -1.7 +34.3 Adjustable-rate mortgage bonds -1.65 -2.2 +26.5 GNMA bonds +0.25 -2.5 +38.8 High-quality corporate bonds, 5- to 10-year +0.04 -3.4 +41.4 Lower-quality corporate bonds, long-term +0.01 -4.5 +46.5 High-quality corporate bonds, long-term +0.20 -4.6 +41.7 U.S. govt. bonds 5- to 10-year -0.01 -3.7 +36.9 Junk corporate bonds -1.34 -3.8 +65.6 Global money market -2.40 -4.3 +47.8 U.S. govt. bonds, long-term +0.24 -4.6 +37.4 Mixed bonds -1.36 -6.0 +46.5 General muni bonds, long-term -1.64 -6.5 +36.0 Global bonds, long-term -1.52 -6.5 +43.8 Calif. muni bonds, long-term -2.55 -7.5 +33.9 Insured Calif. muni bonds, long-term -2.40 -8.5 +35.9
Source: Lipper Analytical Services Inc.
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