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U.S. Bond Funds, After The Fall

January 24, 1995

NEW YORK (AP) _ Among all the letdowns in mutual fund performance over the past year, few have been more keenly felt than the losses sustained by funds that invest in U.S. government bonds.

The Treasury and government-agency bond markets, renowned for their safety from the risk of default, are a magnet for conservative, income-conscious investors who want to take as little risk as possible.

They also attract some customers who are less experienced and knowledgeable than the typical buyer of, say, a stock fund or junk-bond mutual fund.

That makes those investors an unreceptive audience for the kind of performance government bonds turned in last year. According to Morningstar Mutual Funds of Chicago, an average of 599 government bond funds posted a 3.45 percent net loss for 1994, even after counting the dividends they paid.

By last spring, the tide of money that had been pouring into government funds turned to an outflow that has persisted ever since.

Assets in the group, hit by a combination of declining portfolio values and shareholders’ withdrawal of money, shrank by nearly 20 percent, notes Erik Laughlin, a Morningstar analyst. ``Many disillusioned investors have fled,″ Laughlin says.

In many ways, these developments strike most observers as only a temporary setback. The market for government securities remains huge and vibrant, including not only general debts of the Treasury and several specialized government agencies, but also packages of home mortgages that have been bundled together and backed by Uncle Sam.

The market’s big problem last year was an unusually sharp jump in interest rates. Interest rates are cyclical, and do not promise to keep rising indefinitely the way they have in the recent past.

What’s more, as rates rise, pushing prices of existing bonds lower, they make bonds progressively more attractive to potential new buyers.

``The beating the bond markets took last year makes for tremendous opportunities this year,″ says Chip Norton, managing editor of Moneyletter, an investment advisory published by IBC-Donoghue Inc. in Ashland, Mass.

In addition, writes Laughlin in a recent Morningstar report, government bonds and the funds that invest in them stand to benefit more than most other fixed-income investments should the economy slow, as many analysts expect it to.

When a strong economy pushes up interest rates, it also tends to bolster the financial status of corporations, municipalities and other bond issuers that, to one extent or another, lack the top-level credit standing of the federal government.

That improvement can cushion the negative impact of rising interest rates on corporate and municipal bonds. No such effect occurs in the Treasury market.

If the economy slows, however, ``the principle of default risk works in reverse,″ Laughlin observes. In an environment of falling rates and a slowing economy, government bonds stand to benefit most in comparison to corporates and municipals.

So it’s not hard to argue that government bond funds may be a pretty good buy right now.

At the same time, though, there is reason to doubt that these funds are ready any time soon for a return to the kind of boom they experienced in much of the ’80s and early ’90s.

The extended decline in interest rates over that span can’t be replayed from today’s levels, which are far below where rates stood at the start of the ’80s.

Sophisticated investors can bypass funds to buy Treasury securities directly from the government, paying no commissions. Bonds held that way have a known value at a specified maturity date, unlike mutual funds which have continuously managed portfolios that never mature.

Some less experienced investors, meanwhile, may have concluded that they simply want no part of long-term bond funds’ principal fluctuations.

As Laughlin concludes, ``Now that yields are higher, investors may find this the perfect time to buy. Others may find that all but the shortest-maturity funds bear too much rate sensitivity for their risk-tolerance.″

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