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Bond Funds Can Be a Good Investment

September 13, 2006

NEW YORK (AP) _ With some investors wringing their hands about inflation and the Federal Reserve’s efforts to keep it in check, those with bond fund holdings could be forgiven for wanting to take their money and run. But while some market observers see volatility ahead, few are ready to call it quits.

``I would say things are going to get a little bumpy here in September for the bond market, but I don’t think it’s the end of the world,″ said Jeff Tjornehoj, a senior analyst at Lipper Inc. He contends there are still smart plays to be made.

Bonds have faced a more difficult environment in the past two years as the Federal Reserve raised interest rates 17 straight times before pausing last month. While the rate increases hurt bond funds, leaving some investors wary, sentiment changed in late June when Fed comments led investors to believe the rate increase had come to an end.

Bond prices move in the opposite direction of their yield. So as interest rates rise, the prices of bonds often fall because investors refuse to pay as much for a bond that has a lower yield.

``Investors are saying that the Fed is done raising rates and so that’s why you see people taking more risk now,″ said Jim Kauffmann, head of fixed income at ING Investment Management. He noted that it became more acceptable to take risk in areas such as high-yield bonds, which have lower credit-quality ratings.

Kauffmann said the Fed’s comments turned investors’ attention to growth from inflation, with the notion that if growth in the economy moderates then so too will inflation. ``Now that’s a huge leap of faith for investors to make,″ he said.

Still, Kauffmann believes that if interest rates hold bond, funds should have an easier time showing the returns investors are looking for.

The amount of money invested in bond funds is about $1.41 trillion, or about 15 percent of the amount invested in mutual funds overall, according the Investment Company Institute, the mutual fund industry trade group. Displeased with lackluster returns for intermediate to long-term bonds, investors snipped their bond fund holdings in 2004 after having added since 2001.

But the funds saw renewed interest last year, with investors pumping $31.3 billion into the sector, according to ICI. The group attributes the increased investment in part to growth in funds that snap up shares of other funds, such as lifecycle funds. These funds, which aim for a balanced investment portfolio, generally include bond funds.

This year has seen a mixed performance for bond funds, with many of the year-to-date gains occurring in the three months since investors interpreted that the Fed was done raising interest rates.

Through July, however, investors added an impressive $22.7 billion to bond funds this year, ICI figures show.

``The summer has been a great time for bond funds to get back on track,″ Tjornehoj said.

Kauffmann expects that the Fed won’t adjust interest rates when it meets next week but he remains concerned that the effects of the earlier increases haven’t been fully absorbed by the markets.

``There still remains a significant question whether inflation is going to become a problem,″ he said. ``Typically inflation does not peak until after the Fed is done (raising rates).″

A cautious investor, perhaps someone closer to retirement, will likely be more comfortable investing in funds focused on shorter-term bonds, not those whose focus is bonds with 10- and 15-year maturities, said Steve Schoepke, vice president of research and product development at AIG SunAmerica Asset Management. Still, he said investors shouldn’t necessarily shun longer-term maturities. He noted that as the Fed has tightened rates, short-term interest rates have advanced but that longer-term rates haven’t acted in tandem, therefore holding down how much some of these bonds pay out.

He prescribes diversification and, as an example, offered up a ``barbell″ approach, in which an investor’s holdings are a mix of short-term and long-term maturities with few intermediate-term bonds. ``It’s certainly a strategy to mitigate risk and at the same time be positioned, maybe, if you’re on the fence,″ Schoepke said.

Tjornehoj also preaches diversification. ``I would want to have several maturities represented.″ He believes too many investors are convinced they need to be invested solely in funds that focus on maturities of a year or less.

He counsels investors to focus on funds that invest in high-quality bonds and to limit how deeply they venture into bond funds that comprise tempting, but riskier, investments such as debt with lower credit quality or in developing nations. Such funds have shown strong performance but could suffer deep setbacks should there be a downturn in the bond markets. Too often, Tjornehoj said, he sees investors ``chasing performance″ and arriving late.

Rather than focusing on flashy emerging markets funds or high-yield bonds, he suggests investors re-examine corporate and municipal bond funds. ``I still think corporates are a pretty good play. I think they can finish the year out stronger than treasuries.″

Diversification could simply help investors stomach swings that could occur as the markets await answers about everything from inflation and interest rates.

``We may be in for volatile times for the rest of the year,″ Tjornehoj said.