If you're invested in a bond fund because you want income from the dividends it pays, you've surely noticed a reduction in the size of your checks -- and, of course, an increase in your fund's share price -- as bond interest rates have fallen.
If you picked the fund on the basis of your own research, you probably had read warnings that its dividend payments could drop under these circumstances.
If you picked it on a salesperson's recommendation, the possibility should have been mentioned to you.
Either way, you should not have been surprised.
But if the drop in your dividends has been greater than you could reasonably have expected, it could be due to the fund management failure to adequately protect you against call risk (in the case of bonds) or prepayment risk (in the case of mortgage-backed securities). These are the risks that such fixed-income securities can be redeemed or prepaid before their maturity dates and will have to be replaced by others paying lower interest.
Provided a bond issue's terms permit, an issuer may "call" its outstanding bonds for redemption for any of several reasons -- one of which is to reduce interest costs when falling rates make this possible. Even if the issuer has to pay holders of called bonds a premium above their face values, the issuer may save money in the long run by issuing new ones at lower rates.
Similarly, homeowners can prepay mortgages collateralizing Ginnie Mae (GNMA) and other mortgage-backed securities, shortening their maturities, so that they can refinance them and save money, too.
Call risk can be incurred with both investment-grade and speculative bonds, whether corporate or municipal, whose issuers reserve the right to call them when desirable from their -- not the investors' -- viewpoint.
Even a few U.S. Treasury issues have call provisions, as holders of its 7.5 percent, 20-year bonds maturing in August 1993 were reminded last month, when the Treasury called them for redemption in February 1992 -- its first call since 1962.
Although portfolio managers have noted a predictable increase in calls across the range of corporate and municipal bonds, Paul Kaplan, senior vice president of Wellington Management Company, is struck by the slow acceleration of GNMA prepayments.
"Maybe the economy is so weak that people don't feel comfortable paying points," says Mr. Kaplan, whose firm is an investment adviser to Vanguard's GNMA Portfolio and other funds.
"If rates drop from here, prepayments will have to accelerate. There are a lot of nines and tens [9 percent and 10 percent GNMA certificates] out there."
GNMA securities bearing high-interest coupons and callable bonds with approaching call dates are not inherently bad investments.
Even now, as Donald Carleton, manager of several Scudder municipal bond funds, points out, he uses some in short-term funds.
But if you're in a longer-term fund that owns them, you need to remember that a continued fall in interest rates can lead not only to reinvestment at lower rates but also to capital losses (if securities were bought for more than they'll be redeemed for) and a lower total return.
Portfolio managers who are concerned about call or prepayment risk act accordingly. They choose issues paying less than peak rates and having distant call dates.
Instead of reaching for yields, they give up a bit of income but reduce the possibility of its steep drop -- and also may enjoy more of a bounce in their securities' prices.
How can you tell whether a taxable or tax-exempt bond fund you own, or are considering, is likely to give you adequate call or prepayment protection?
You can begin by comparing its income dividend distribution rate for the latest 12 months with the average of its category, as calculated by Lipper Analytical Services.
If, say, a corporate bond fund's rate exceeded the average of 7.8 percent or a general municipal bond fund's exceeded the average of 6.3 percent for the period that ended Oct. 31 (see accompanying table), it does not automatically mean the fund's management is disregarding call protection.
Its portfolio could be invested in securities with longer-than-average maturities or below-average credit quality. But if that's not the case, call the fund's 800 number and ask how vulnerable the portfolio is to call or prepayment risk.
You also might check the last report to shareholders to see whether the management expressed its concern about such risk.
If the distribution rate is below the group average, you may be provided protection, but you can't be sure without checking. It could be due to below-average maturities or above-average credit quality -- or, of course, to above-average expense ratios.
lTC Whatever it takes, you should find the effort worthwhile. As Robert A. Dennis, portfolio manager of Massachusetts Financial's Managed Municipal Bond Trust, put it: "Bonds with the best call protection do the best."
Average 12-month yields