So You’re Thinking ‘Government Bonds’ . . .

All of a sudden, investing in the federal government doesn’t seem like such a bad idea.

Or, at least, investing in Uncle Sam’s IOUs.

With global stock markets in turmoil, individual investors who had shunned U.S. government bond mutual funds in recent years--pulling a net $13.1 billion out of these portfolios in 1996 and 1997--have done an about-face in 1998.

Through the end of June, investors plowed a net $622 million into government bond funds. They’ve been rewarded with average total returns of 3.4% to 7.2% thus far this year (depending on the specific type of fund), thanks to interest earnings and appreciating bond values as market yields have tumbled.

By contrast, the typical domestic stock fund now is up just 2.5% year to date, in the wake of Wall Street’s steep slide in recent months.

No wonder that Trimtabs.com, a Santa Rosa research firm, projects an additional net $1.6 billion will flow into government bond funds in August alone.

“What’s going on around the world is phenomenal,� notes Jim Gammon, president of Lebenthal Asset Management in New York City. “Everybody is running for safety.�

But just how safe are government bond mutual funds? And how can you tell which ones are risky and which aren’t?

To answer that, a brief discussion of risk is in order.

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U.S. government bonds--Treasury securities and other government agency bonds--are considered relatively safe by both foreign and domestic investors because they aren’t subject to something called “credit risk.�

That is to say, although a company that issues debt can end up in bankruptcy--and smaller foreign countries may have difficulties meeting debt payments--the chances of the federal government doing so are nil.

However, that’s not to say that government bonds are risk-free.

In 1994, for instance, when market interest rates shot up as the Federal Reserve tightened credit repeatedly, the typical government bond fund posted a negative return of 3.5% for the year--despite earning more than 6% in interest.

What happened?

A fixed-rate bond’s price moves in the opposite direction of market interest rates. When rates rise, the price of older bonds that carry lower fixed yields falls.

And when market rates fall--as they have this year--older bonds rise in value because their yields are better than what investors can find in new bonds.

A bond’s (or bond fund’s) “total return,� therefore, reflects both interest earnings and any change in principal value of the security itself resulting from market rate moves.

So there is risk to owning even a U.S. Treasury bond fund.

But there are ways to minimize one’s exposure to this so-called interest rate risk.

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Here are five things bond fund managers say safety-minded investors ought to consider before purchasing a government bond portfolio, either through a company-sponsored 401(k) retirement savings plan or in a taxable account:

* What does the fund own? “Not all government bond funds are created equal,� says Greg Schultz, a principal with Asset Allocation Advisors in Walnut Creek, Calif. “So when you’re talking about bond funds, you’ve got to be leery of the games that mutual fund companies play.�

Whereas some government bond funds invest strictly in U.S. Treasuries, others load up on mortgage-backed securities to boost returns.

Unlike the benchmark 30-year Treasury bond, which is yielding just 5.46% today, some mortgage-backed bonds issued by Fannie Mae, Freddie Mac or Ginnie Mae are yielding twice or even three times as much.

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That income may boost short-term returns, Shultz notes, but it adds an additional component of risk to the overall portfolio.

When market interest rates fall, for instance, the value of mortgage-backed securities also will fall, because a drop in rates will likely lead to another round of mortgage refinancings.

That can hurt a government bond fund’s performance if money from mortgage bonds that are paid ahead of schedule must be reinvested at lower rates.

“If even half of your fund is invested in 8% or 9% mortgage-backed bonds, you’re going to be subject to tremendous prepayment risk,� says Loomis Sayles managing director Kent Newmark, who oversees the firm’s fixed-income assets.

Ned Notzon, a managing director at T. Rowe Price Associates, says safety-minded investors who are drawn to government bonds for safety ought to consider a bond fund that invests almost entirely in U.S. Treasuries.

That would include funds like Vanguard’s Fixed-Income Intermediate-Term U.S. Treasury Portfolio, which has delivered annualized returns of 7.5% over the past three years through July 31 (no load; minimum initial investment: $3,000; [800] 662-7447); and the American Century-Benham Target Maturities Trust series (no load; minimum initial investment: $2,500; [800] 345-2021).

* Is it a short-term, intermediate-term, or long-term government bond fund? Historically, long-term government bonds have delivered annualized total returns of 5.6%, vs. 5.4% for intermediate-term bonds and 3.8% for Treasury bills.

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Many investors naturally seek out the highest returns and so choose longer-term bonds.

But longer-term bonds expose investors to greater interest rate risk, since these bonds tie up money at fixed rates for a greater period of time.

Although this additional risk is usually rewarded with greater yields, that’s not the case today.

The difference in the yield of a five-year Treasury note and a 30-year Treasury bond, for instance, is only about 0.30 percentage points today.

“Long-term bond holders just aren’t getting compensated with additional yield,� says Dave Schroeder, senior portfolio manager in charge of American Century Funds’ government debt. That why many financial planners suggest risk-averse investors stick with short- and intermediate-term bond funds.

You may be wondering: Why would anyone invest in a long-term government bond fund, then? Essentially, these investors are making a bet that the Federal Reserve will cut rates sooner rather than later, driving all market interest rates lower.

But as Schroeder notes, there is a possibility that the Fed will raise rates should the Asian economic crisis blow over, should the stock market recover, and should the economy continue to grow. And that’s likely to hurt long-term funds disproportionately.

* What is the fund’s duration? Duration is a statistical measure of a fund’s sensitivity to interest-rate fluctuations.

Though intermediate-term bond funds will be less exposed to interest rate risk than long-term funds, investors need to consider a fund’s duration to get a real sense of how much their portfolios can gain or lose when rates move.

Bob Auwaerter, manager of Vanguard’s Fixed-Income Long-Term U.S. Treasury Bond Fund, notes that a bond fund with an average duration of five years is likely to gain 5% should interest rates fall 1 percentage point. Should interest rates rise 1 point, though, this fund will lose 5%. A fund with a duration of 10 years is likely to be twice as volatile.

Given the risk of what the Fed will do--and given the fact that longer-term bonds aren’t paying much additional yield--Loomis Sayles’ Newmark suggests sticking with bond funds with average durations of three to five years.

* How high are the fund’s fees? Total expenses for the average government bond fund are 1.12% of assets annually. Although that may seem little in the context of a red-hot growth stock fund that’s returning 30% a year, that represents a major chunk of your returns in a bond fund gaining 7% a year.

So financial planners advise investors to stick with low-fee funds, such as Galaxy II U.S. Treasury Index, which charges just 0.4% in expenses (no load; minimum initial investment: $2,500; [800] 628-0414); or T. Rowe Price U.S. Treasury Intermediate, which charges just 0.64% (no load; minimum initial investment: $2,500; [800] 638-5660).

* What is your time horizon? A recent survey by John Hancock Mutual Life Insurance Co. found that nearly half of all respondents thought they could not lose money in a bond fund. This is untrue, as the 1994 experience showed.

American Century’s Schroeder offers this simple advice to avoid exposing yourself to significant risk of loss: “Buy bond funds whose average maturity matches your investment time horizon.�

Average maturity refers to when the average bond in the fund is scheduled to come due.

Shorter-term bonds normally will yield less than longer-term ones, of course. So you will have to accept a lower yield with a shorter maturity.

But that also means your principal value will be better protected against potential losses.

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Times staff writer Paul J. Lim can be reached at [email protected].