Amid turmoil in bonds, stay focused on objective

MUTUAL FUNDS

March 06, 1994|By WERNER RENBERG | WERNER RENBERG,1994 Werner Renberg

When the Federal Reserve System's Federal Open Market Committee decided in early February "to increase slightly the degree of pressure on reserve positions," its impact on the bond market was greater than the wording of its statement would have suggested.

It was more like the impact that a hard kick makes on an ant hill. And, like a colony of ants, bond investors became disoriented.

The FOMC action, which resulted in a small increase in short-term interest rates, was taken "to sustain and enhance the economic expansion" by countering emerging inflationary pressures that, among other things, could cause long-term interest rates to soar. To many investors, this was reassuring.

But many others inferred that the FOMC had detected hints of serious inflation and would take additional steps to preclude it.

Instead of being reassured, they sold or avoided bonds, causing the higher yields that the FOMC move should have aborted.

If you own, or had been thinking of owning, one or more bond funds, you may have wondered: What should you do amid this turmoil?

A few suggestions may be helpful:

* Stay calm. Remember that bond prices are no less immune to emotional factors -- and overre action -- than stock prices.

* Focus on the investment objective you want a bond fund to achieve (income, diversification in a growth-oriented portfolio), how long you can be invested, and how much volatility you can tolerate.

* If you own a fund, affirm that it's suitable for you. If it is not, or if you don't yet own one, look for one in a fund category that is compatible with your objective and risk tolerance.

You may conclude that an intermediate-term fund -- one whose weighted average maturity is between five and 10 years -- makes the most sense, usually being less subject to share price volatility than a long-term fund and more rewarding than a short-term fund.

Lipper Analytical Services classifies taxable intermediate-term funds into three groups: U.S. Treasury funds, U.S. Government funds that own Treasuries plus other governments, and investment-grade funds that own both governments and investment grade corporates.

The latter may be what you're looking for (unless you are in a high tax bracket and should be in a tax-free fund) because their corporate holdings should enable them to produce higher returns than the others without exposing you to significant credit risk.

The top two funds, PIMCO Total Return and Harbor Bond Fund, are both managed by William H. Gross, a managing director of Pacific Investment Management Co.

Gross says he has the same goal for both: a total return of 1 percent above Lehman Brothers' Aggregate Bond Index, which measures the performance of the entire U.S. investment grade bond market -- a universe with an average intermediate maturity of around nine years.

In recent years Gross has beaten his goal with annual returns of 12 percent to 13 percent, and he credits three factors for that: timely changes in the portfolios' maturity and duration (an indicator of a portfolio's sensitivity to interest rate changes), timely rotation among sectors and some "high-quality junk" bonds.

While agreeing that a portfolio with an average intermediate-term maturity may be right for many investors, Gross cautions against leaping to the conclusion that this means buying only intermediate-term bonds.

Concerned that they may be more affected by higher interest rates, he advocates a "barbell" approach -- that is, a portfolio of long and short maturities whose weighted average maturity is intermediate.

A "barbell" strategy is also what Catherine L. Bunting follows in running TNE Bond Income Fund. Like some competitors, she has been raising her stake in Treasuries as the spreads between their yields and corporates have tightened. Not long ago, 80 percent of her portfolio was in corporates; it's now 55 percent to 60 percent. Her search for good values led her to add some Canadian provincial securities in recent months.

Jay C. Harbeck has about 75 percent of Merrill Lynch Corporate Bond Fund's Intermediate Term Portfolio in corporates. That's also down from 80 percent, though, as he, too, has been raising his Treasury holdings because of the tight spreads. Harbeck also has let cash rise but won't let it exceed 10 percent.

Michael Gray, portfolio manager of Fidelity Intermediate Bond Fund, slashed his corporate holdings to below 20 percent as spreads tightened and built up Treasuries to nearly 40 percent. About 25 percent is in foreign bonds, two-thirds of them denominated in U.S. dollars and one-third in foreign currencies (mainly European).

Like other managers of the group's leading funds, Gray believes that the bond market has overreacted to the Fed action. But, also like his competitors, he has adjusted the fund's already low risk level in part by shortening his portfolio's duration. Said he: "The market is always right, no matter what I believe."

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