For every $3 invested in equity mutual funds last year, more than $4 was invested in bond and income funds as investors searched for higher-yielding alternatives to CDs and money market funds.
This year, with sales of both running ahead of 1991 sales, bond funds are outselling equity funds by a similar margin, and no bond funds are selling better than government bond funds.
If you're considering buying into such a fund, you'll find it worthwhile to think through the potential rewards and risks before making a selection. Remember that government bond funds choose from a huge variety of government and government-related securities -- with different risk characteristics -- maturing in one to 30 years.
As with other bonds, the shortest maturities tend to offer the lowest yields and involve the least risk that their prices will fall when interest rates rise. The longest maturities tend to offer the highest yields and expose you to the greatest market risk; they also provide the greatest potential for gains when rates fall.
L To keep things simple, let's divide them into three groups:
1. Securities issued by the U.S. Treasury and backed by the full faith and credit of the U.S. government.
2. Other securities with similar backing. They include mortgage-backed securities issued by private lending institutions but whose interest payments and principal repayments are guaranteed by the Government National Mortgage Association (Ginnie Mae).
3. Securities issued by government-related institutions that have implicit government support but no government guarantees. They include two major issuers of mortgage-backed securities: Federal Home Loan Mortgage Corp. (Freddie Mac) and Federal National Mortgage Association (Fannie Mae).
While "Freddie Macs" and "Fannie Maes" differ from "Ginnie Maes" in certain respects -- such as the government's "full faith and credit" backing -- they also share important features: Their holders receive a "pass-through" of the monthly principal and interest payments made on the pooled mortgages that serve as their collateral. When interest rates fall, holders of mortgage-backed securities receive additional, unscheduled principal repayments as people pay down their mortgages and refinance.
To compensate investors for prepayment risk -- the risk that they'll have to reinvest such money at lower rates and receive less income than they had expected -- mortgage-backed securities offer higher interest rates than Treasury securities of comparable maturities.
Government bond funds follow different investment policies in choosing from the three broad securities groups.
Some are concentrated only in U.S. Treasury securities or Ginnie Maes. Others may choose from among the three principal types of mortgage-backed securities.
By far the largest number -- about 120 -- have flexible policies permitting them to invest across the range of government securities and maturities and to change portfolio composition as managers deem appropriate.
A look at some of the leading performers gives you an idea of the strategies that they're following now.
Gary Madich, who manages both Federated Income Trust and Federated's Government Income Securities, relies heavily on mortgage-backed securities. The first is fully invested in them; the second is about 20 percent in short-term Treasuries. Being very selective, he's buying Ginnie Maes with 8.5 to 9.5 percent coupons that are less likely to be prepaid.
Robert S. Dow, portfolio manager of Lord Abbett U.S. Government Securities Fund, looks ahead 10 years and bases )) his portfolio on what he sees: long-term bonds down to 7 percent -- possibly 6 -- percent. He's about 70 percent in mortgage-backed securities -- with an average coupon of 8.375 percent -- 20 percent in long-term zero-coupon Treasury obligations, and about 10 percent in short-term securities bearing high coupons.
Charles Heebner, manager of Value Line U.S. Government Securities Fund, is reducing his Treasury holdings, which he had raised to about 40 percent last year, and adding to mortgage-backed securities. Concerns about the strength of the recovery, inflation and election uncertainties make him less bullish about interest rates, he says.
! 1992 Werner Renberg