One day you hear that interest rates are going to rise because the economic recovery is likely to be stronger than expected. The next day you hear that rates are going to fall because the recovery is likely to be weaker than hoped for -- and may be followed by another recession next year.
If you want to invest in a bond fund, and you know that results from such investments depend largely on interest-rate behavior, which scenario should you count on in planning your strategy? Do you suppose that the views of some eminent economists could help?
Such expert advice became available a few days ago, when the Wall Street Journal published results of its semiannual survey of forecasts by 40 leading economists. The averages of their interest-rate predictions: a three-month Treasury bill rate of 6.08 percent by next June 30, up from 5.62 percent this June 30; and a 30-year Treasury bond yield of 8.14 percent, down from 8.41 percent.
These average projections seem to be credible -- until you look at the underlying individual predictions and realize how much the economists disagreed. Their T-bill yield forecasts ranged from 4.50 percent to 7.40 percent; their long-term bond yield forecasts ranged from 6.00 percent to 9.50 percent.
Your confidence in these consensus forecasts may be even more shaken by their track record, of which the Journal faithfully reminds us. Last December, the polled economists underestimated how much the T-bill rate would fall, predicting an average 6.14 percent yield by June 30.
On the other hand, they were much too optimistic about where 30-year bond rates would be. They predicted a drop from 8.24 percent to 7.65 percent on the average, instead of the increase that actually occurred. It was not the first time they had the direction wrong.
Under the circumstances, what can you base your strategy on?
BInstead of tuning into short-range forecasts, focus on widely held assumptions about long-range economic trends, some fundamentals of bond and bond-fund investing, and your ability to tolerate risk.
Try the following rationale, which leads to the conclusion that this is the time to go for a long-term, high-grade bond fund:
* Inflation expectations are a major influence on long-term interest rates. Many believe that inflation will remain under control in the years ahead -- even if there are occasional scares. Sooner or later, long-term bond rates should fall -- and prices should appreciate -- to reflect these projections.
* Interest rates for long-term securities are normally higher than those for short-term securities of the same credit quality. Now, the reward for going long is unusually high, as illustrated by the spread of around 2.90 percent between three-month and 30-year Treasury securities. Sooner or later, it should narrow.
* Interest rates for the highest-quality corporate securities (those rated Aaa) are normally higher than those for Treasury securities of the same maturity. Lately, the spread has been reduced to around 0.50 percent. Bonds in the next three ratings (Aa, A, and Baa) are still regarded as investment grade and yield more.
* Income from long-term bond funds is less volatile than income from short-term bond or money-market funds. But their share prices are more volatile in the short run because long-term bond prices are subject to greater fluctuation. They fall more than short-term bond prices when interest rates rise and rise more when rates slide.
If your goal is to generate high income or diversify a growth-oriented fund portfolio, and if you can tolerate interim share price volatility while aiming at a long investment horizon, a fund from Lipper Analytical Services' A-rated category may be right for you.
When you study data for the group, such as the funds in the table, you'll quickly spot differences in their maturity and credit quality strategies.
Consider these factors when selecting a fund:
Vanguard's Investment Grade Bond Portfolio stands out among the leading performers with its concentration in long-term bonds, having an effective average maturity of almost 23 years. John Hancock Bond Trust and Putnam Income Fund's portfolios run around 15 to 16 years, while the other top funds have kept average maturities to about 10 years.
Investment-grade corporate bonds -- in various mixes of the four grades -- account for anywhere from about 80 percent of fund assets for Vanguard to about 40 percent for Kemper Income and Capital Preservation Fund. A few funds also own bonds of less than investment grade; for instance, Bond Fund of America and Putnam have about 20 percent of their assets in "junk." U.S. government securities -- and, in a few cases, some international bonds -- round out the portfolios.
"The large spread between short- and long-term interest rates should be enough to induce even the most risk-sensitive people to look," says Ian A. MacKinnon, Vanguard senior vice-president.
Consider the portfolio maturity and credit quality that you think you'd feel comfortable with to find the right balance between risk and reward.