Whether you invest in bond funds to earn income or to diversify a growth-oriented portfolio, you know that you have to assume greater risk in the hope of achieving higher returns -- if you're able and willing to do so.
You can aim at earning higher returns by assuming greater credit risk -- the risk that corporations or governmental units issuing bonds won't pay interest or repay principal when scheduled -- by buying a fund invested in bonds of lower credit quality.
You can assume greater call or prepayment risk -- the risk that securities bearing high interest coupons will be paid off before maturity, if interest rates fall, and have to be replaced by others offering less -- by buying a fund whose manager seeks issues with the highest coupons.
Or you can assume greater interest rate risk -- the risk that bond prices will fall if interest rates rise -- by buying a fund invested in long-term bonds that won't mature for more than 10 years.
At a time when interest rates for the longest-term bonds exceed those of short-term issues of comparable credit quality as well as the inflation rate by exceptionally large margins -- 4 percent or so -- you may conclude that funds incurring interest rate risk seem attractive.
The case for investing in long-term bond funds is based on more than today's relatively high yields. While the prices of long-term bond funds may be more volatile than those of short-term funds, their dividends tend to hold up better when rates slide.
Moreover, even though we've already seen an increase in bond prices as interest rates have fallen, additional moderate capital appreciation is possible in the next few years if inflation remains under control and government policies don't ignite new inflation fears.
You may find a suitable prospect in the group classified by Lipper Analytical Services as A-rated corporate bond funds, which are at least 65 percent invested in securities rated in the top three of the four investment grades (Aaa, A, and A, according to Moody's) and in government issues. Consider one of its leaders if:
* You are planning to be invested for several years.
* You agree that the bonds of our most creditworthy corporations are good enough for you.
About 80 percent invested in corporate bonds rated A or higher, the Vanguard Investment Grade Corporate Portfolio maintains one of the group's longest maturities -- the weighted average is about 20 years -- and its lowest expense ratio. If the spread between government and corporate bonds widened, the fund would go to 90 percent corporates, said Paul Kaplan, senior vice-president of Wellington Management Co., the fund's investment adviser.
Managements of other funds in the group prefer average maturities closer to 10 years because they involve less interest rate risk but nevertheless yield almost as much. These funds did well in 1991 as yields of intermediate-term securities fell more than long-term yields.
Another major difference among funds in the group is in how they divide their core holdings according to credit risk. Some, such as the Vanguard and Putnam Income funds, are primarily in corporates. "They represent value," said John W. Geissinger, Putnam's portfolio manager.
Others, such as Scudder Income Fund, have as much as 40 percent of their assets in U.S. Treasury and government agency securities, although William A. Hutchinson, Scudder's portfolio manager, did add to his corporate holdings last year.
To enhance yields, several funds devote minor portions of their assets to bonds of less than investment grade, or "junk" bonds. Mr. Geissinger has about 20 percent of the portfolio in them, down from 25 percent partly because some of his securities were upgraded. James K. Ho, portfolio manager of John Hancock Bond Trust, has about 15 percent.
While funds such as Vanguard's and Scudder's try to minimize call risk by buying noncallable bonds, Mr. Ho has "a lot" of callable paper -- issues selling at premium prices because of their high coupons. "We know the dividend has to come down," he says.
Several of the managers have enhanced their returns by buying bonds issued by foreign corporations and governmental units. Most have confined these purchases to bonds denominated in U.S. dollars, such as those of Canadian provincial utilities bearing 15 percent coupons (and due to be called in five or six years). Some, such as Mr. Geissinger, also incurred a small degree or currency risk by investing in bonds denominated in other currencies.
A-rated corporate bond funds
(Ranked according to 5-year performance)
.. .. .. .. .. .. .. .. .. .Annual rate of return .. .. .. .***12
.. .. .. .. .. .. .. .. .10.. .. .. 5.. .. ..1.. .. .. .. .. mo.
Fund.. .. .. .. .. .. years.. ..years.. ..year.. ..YTD.. ..yield
.. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ..
Vanguard Investment.. 13.5%.. ..10.2%.. .20.9%.. (2.4%).. ..8.1%
Grade (NL).. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .
IAI Bond (NL).. .. .. 13.4%.. .. 9.5%.. .17.3%.. (4.0%).. ..7.0%