Sun, Aug 18, 2002 page10

• Bonds start to get risky

  INVESTOR STRATEGY Once considered a safe haven from tumultuous share markets, low interest rates have made buying high-quality bonds a questionable move

  • NY TIMES NEWS SERVICE
  • • 
    • 
    • 

  Investors who have sought a refuge from stocks by pouring money into bond funds may need to prepare for a storm, say some bond managers, who worry about the prospects for intermediate and long-term bonds.

  Short-term and long-term interest rates have already dropped to their lowest levels in decades. And last week, amid signs that the economy may be stalling, the Federal Reserve indicated that it was prepared to cut short-term rates further. While longer-term rates could keep dropping, too, there is a good chance that they are already near a bottom, several analysts said.

  Because interest rates and bond prices move in opposite directions, rising interest rates would lower the prices of bonds. And because bonds of longer maturity are more sensitive to interest-rate moves, long-term bonds would fall the most.

  

  Robert Rodriguez, manager of FPA New Income in Los Angeles, collects novelty wine bottles with economic themes. He says the outlook for longer-term bonds is cloudy.

  PHOTO: NY TIMES

  "I think buying high-quality, long-term bonds today is extremely risky," said Robert L. Rodriguez, manager of the FPA New Income fund in Los Angeles. He also said investors should think carefully before buying intermediate-term bonds. Long-term bonds generally have a a maturity of 10 years or more, while intermediate-term bonds have a maturity of four to 10 years.

  Similarly, Scott F. Richard, head of the investment-grade bond team at Morgan Stanley Investment Management, said: "We believe now is not the time to add to an intermediate or long-term bond position. If you're going to leave the stock market and you're after a safe haven, our view is this is a good time for short-term bonds."

  Even if short-term rates are cut further by the Fed, intermediate- and long-term rates would not necessarily follow, because the central bank has no direct control of longer rates. And if financial markets expect the economy to expand rapidly -- because of Fed action or any other reason -- intermediate- and long-term rates would move higher.

  Based on the 4.09 percent yield on a 10-year Treasury note on Tuesday, an investor would lose 1.73 percent of his capital over the next six months if interest rates rose by just one-half of 1 percent, Rodriguez said.

  Interest rates are now so low that even a tiny drop in the price of a bond can eliminate a bond fund's return, he said. "You just don't have any coupon to protect you," Rodriguez said.

  The decline in interest rates over the last few years led to a bond market rally. And as the stock market has struggled recently, investors have poured money into bond funds, adding US$88 billion last year alone, according to the Investment Institute.

  So far this year, they have put in an additional US$58.5 billion. Taxable bond funds are up 2.1 percent, on average, this year through Thursday, while domestic stock funds are down 19.1 percent.

  Total Return

  At the end of July, the Pimco Total Return bond fund, which has returned 5.3 percent this year through Thursday, had US$60 billion in assets, making it the second-largest mutual fund, ahead of Fidelity Magellan, at US$59.9 billion.

  The biggest is still Vanguard 500 Index, which tracks the Standard & Poor's 500 and has US$70 billion.

  The bond rally may not be entirely over, but Rodriguez says the current low yields have led to significant risks for intermediate and long-term securities. He cited a growing federal budget deficit, which tends to drive up interest rates, and a faltering dollar, which may hurt foreign demand for American securities.

  Not all bond managers share his concerns, but Rodriguez has a strong track record. His fund has outperformed 97 percent of its peers in intermediate-term bond funds over the last 10 years, according to Morningstar Inc. In the horrendous bond market of 1994, it was one of only three intermediate-term bond funds that managed to avoid losing money, said Alan Papier, a mutual fund analyst at Morningstar.

  Richard contends that intermediate- and long-term bond prices reflect an overly pessimistic view about the Federal Reserve's ability to get the economy moving again.

  "The market has built in a very anemic recovery, which in essence is saying the Fed will not be effective," he said. "We think that's incorrect. Intermediate and long-term rates are likely to rise."

  Managers at Pimco share some of these concerns. Mark Kiesel, an executive vice president at the company, said that only a small upward move in rates would be needed to offset the slim yields on intermediate-term Treasuries. Two-year Treasuries currently yield about 2.26 percent, while five-year Treasuries yield 3.42 percent.

  Pimco has kept the duration of its intermediate-term bond portfolios in line with the Lehman Aggregate Bond Index, at 3.9 years. Duration is a measure of a bond's sensitivity to interest rates.

  Kiesel favors foreign bonds with maturities of five to 10 years, which he said are more attractively priced than those issued in the US.

  Bullish about bonds

  Some bond managers are more bullish about US bonds, largely because they are pessimistic about the economy. Robert S. Kapito, vice chairman of BlackRock Inc, said, "We think longer rates will actually decline as investors gain confidence the Fed will keep interest rates low."

  Kapito contends that the economy will not recover until late 2003 and that investors who stay short will lose out on the higher yields offered by intermediate and long-term bonds.

  Bob Auwaerter, a senior fixed-income portfolio manager at the Vanguard Group, says that interest rates are not likely to move significantly higher until next year, but that investors should be aware that they are taking on greater risk if they hold long-term bonds. A mix of short and intermediate-term bonds would best serve investors now, he said. "That way, you get diversification of interest rate sensitivity," he said.

  Still, for investors looking for a haven, better bets are short-term bond and money market funds, Richard said. When interest rates start to rise, their prices will decline far less than those of bonds with longer maturities, but their yields will reflect those rate increases faster, said Thomas Atteberry, who works with Rodriguez on FPA New Income.

  The funds that will pass along rate increases most rapidly will be money market funds, Papier noted. The average maturity of the securities in these funds is 52 days, which means that managers will be able to replace lower-yielding securities with those of higher yields within two months.

  For now, of course, the main problem of money market funds is their exceedingly low yield -- 1.26 percent, on average, according to iMoneyNet, a research firm.

  Short-term bond funds are a more rewarding alternative, Papier said. The average trailing 12-month yield of short-term bond funds tracked by Morningstar was 4.4 percent through July.

  Papier's picks

  Among Papier's current picks are SSgA Yield Plus, with a yield of 2.36 percent through July, and the Vanguard Short-Term Bond Index, which tracks the Lehman Brothers 1-5 Year Government/Corporate index. The fund's yield was 4.96 percent.

  Sophit Lee, a certified financial planner and managing director of Docsa Capital Management in Portage, Michigan, recently moved most of her 100 clients with fixed-income assets out of intermediate-term government bond funds and into short-term bond funds.

  Among the funds Lee uses are Turner Ultra Short Duration, Vanguard Short-Term Treasury and BlackRock Low Duration Bond. These funds all have low expenses, she said.

  "Even though investors may be tempted to go after the higher yields of long-term bonds," she said, "at this time, we don't think investors are compensated for the risks they have to take."
• Most Popular

  • 1

    PSG beaten by Monaco before Chelsea game

  • 2

    Yamal bends Barcelona past Athletic Bilbao

  • 3

    West Ham beat Brentford on penalties to advance

  • 4

    Taiwan fans roar for their team at WBC

  • 5

    Taiwan’s largest snake fossil, at 4m, found in Tainan