After reading the prospectus of a popular fund that invests in U.S. Treasury and GNMA securities, a reader wants to know: "If the interest and principal repayment are guaranteed by the U.S. government, what concern should I have about the fund's share price? How much can it fluctuate? What do I stand to lose?"
It's true, of course, that securities backed by the full faith and credit of the government don't involve credit risk -- the government can always tax us or borrow anew to meet its obligations. Thus, the prices of its bonds, unlike those of corporate, state, or local governments, won't fluctuate because of changes in the issuer's creditworthiness.
But government bond prices, like those of corporates and tax-exempts, can and do fluctuate because of changes in interest rates. They can fluctuate a lot.
Therefore, the share price, or net asset value (NAV), of a bond fund invested in Treasuries -- or in other taxable securities of tax-exempts -- can rise and fall, too.
If you're considering a bond fund and plan to take your income dividends in cash, you also need to think about how stable the principal value of your investment would be. Although you can study the 10-year NAV data you find in a fund's shareholder zTC report and prospectus, you may find it useful to view the figures in a broader perspective.
For this purpose, the historic principal-only performance data recently calculated by Lipper Analytical Services for 27 bond fund categories (excluding single-state municipal funds) come in handy. They differ from Lipper's more widely used total return data in that they don't include reinvested dividends.
The table, which shows the average performance for the best and worst groups in each year of the last decade, highlights the wide ranges of performance, as well as the variation that has characterized groups' results. Bearing in mind that some individual funds outperformed their groups' averages and others underperformed, you'll note:
* A group can be the best one year and the worst the next year, or vice versa. None has consistently been one or the other.
* In years when long-term interest rates fell considerably, such as 1982, 1985 and 1986, the best performers did very well and the worst didn't do badly.
* Except for 1985, at least one group had an average loss in every year, but only in 1987, when interest rates rose the most, were virtually all groups down. This year is off to a disappointing start.
* The pervasive impact on performance of interest-rate fluctuations was most clearly evident in target maturity funds, which invest in the highly volatile zero coupon U.S. Treasury securities.
Given that principal-only performance is primarily based on the investment objectives and policies of a fund and on the manager's skills -- such as changing a portfolio's maturities mix, buying or selling securities, or writing call options -- choosing a well-managed fund is especially important.
Annual fund operating expenses normally can't affect principal, because they are deducted from investment income before the payment of dividends. But transaction costs incurred in buying and selling securities can. Holding these down, through judicious trading and large-scale transactions, can help.
Although the table's data for individual years may suggest that positive returns could offset negative returns, it's necessary to look at Lipper's cumulative data for the five and 10 years ending in 1991 to get a more precise picture.
With the exception of high current yield funds, all fund groups in operation for the last 10 years had positive principal-only results, ranging from a cumulative 6.86 percent for adjustable-rate preferred funds to 89.57 percent for convertible securities funds.
What pointers can you get from all this?
* Avoid relying on a volatile group, such as high current yield funds, for income.
* As an alternative to taking all dividends, consider reinvesting them and redeeming shares for the cash you need at a rate slightly below the dividend rate.
This would enable you to benefit at least modestly from compounding of the fund's income.