When the Federal Reserve acts to stimulate the U.S. economy by initiating cuts in interest rates, as it did again recently, the impact on economic growth usually is not quickly evident.
Prospective business and individual borrowers, who may want to build plants or homes, first must decide to borrow what they need.
But lenders -- investors who make money available by buying U.S. Treasury securities, bank certificates of deposit and other corporate and government obligations -- can feel the impact fairly fast as their interest income declines. Just how fast depends on the maturities of the debt instruments they hold that must be replaced.
The effects can be severe for retired people and others who depend substantially on income from Treasury bills or CDs or from money market funds that own such assets. With yields around 3.5 percent, their after-tax returns are likely to be under 3 percent.
If, after the long slide in money-market rates, you still remain substantially invested in money-market funds or instruments despite your need for investment income, you, too, may find it rewarding to move at least some of your money into one or more bond funds.
Of course, you should only consider such a move if you plan to be invested for several years and thus can accept the risks of short-term volatility that such funds involve.
The principal risk in investing in bond funds is interest-rate risk -- the risk that their share prices will fall when interest rates rise.
To minimize or avoid this risk (and to profit by knowing when rates will fall and prices of bonds and bond fund shares will rise), it would be useful to be able to predict interest rates correctly. Unfortunately, nobody can do so consistently.
Only a few days ago, the Wall Street Journal provided its latest semiannual proof of the fallibility of forecasts by 40 leading economists. When they were surveyed six months ago, their predictions for the 13-week T-bill rate on June 30 had ranged from 4.5 percent to 2.75 percent; the actual rate: 3.63 percent. For 30-year bond yields, they had ranged from 8 percent to 6 percent; actual: 7.78 percent.
Given that the experts' projections are far apart, what can you do to get started in selecting one or two bond funds that could be suitable for you?
Avoid trying to predict near-term interest rates. Concentrate instead on becoming familiar with the essential risk and reward characteristics of various fund types.
Then determine which funds in the categories you're considering are likely to offer you the best returns at the least risk.
The classification system developed by Lipper Analytical Services uses about 25 categories for taxable and tax-exempt bond funds to accommodate a variety of risk-reward characteristics.
With performance data now available through the second quarter, you can make an up-to-date comparison of how funds in the various categories have performed (before taxes and any sales charges).
Bear in mind that, when you're ready to select a fund within a group, you'll want to look for one that has achieved -- and should be expected to continue achieving -- above-average performance.
Normally, higher risk should be rewarded with higher returns.
Thus, you would expect yields and total returns -- and interest rate risk -- to be lowest for short-term funds, whose portfolios have weighted average maturities of five years or less. They should be higher for intermediate-term funds -- those whose weighted average maturities run from five to 10 years -- and highest for funds with maturities exceeding 10 years.
In each maturity group, funds primarily invested in U.S. Treasury securities involve the least credit risk; those primarily invested in investment-grade corporate bonds involve higher credit risk.
Funds invested in GNMA securities involve prepayment risk -- the risk that their underlying mortgages will be prepaid when interest rates fall and the proceeds will have to be invested at lower rates. High yield -- or junk bond -- funds involve the greatest credit risk.
World income funds involve exchange rate risk -- the risk that the foreign currencies in which their bonds are denominated will weaken against the dollar.
Flexible income and convertible securities funds involve some stock market risk -- flexible income funds because they tend to be partially invested in stocks and convertible securities funds because their bonds and preferred stocks may be converted into common stocks.