In a bear market, bond funds can be 'safe' if interest is reinvested

STAYING AHEAD

July 11, 1994|By JANE BRYANT QUINN

NEW YORK -- Buy and hold, buy and hold. That's the credo of long-term investors, especially when they own mutual funds. XTC Even though bear markets hurt, you'll more than recoup your losses when prices go back up.

But the data that prove that point are always drawn from stocks. What about bonds? Are they also safe to buy and hold? The answer is: sometimes yes and sometimes no, depending on how your investment is used.

Almost all bond-fund investors have been running scared since February, when bond prices broke. Share prices on Treasury-bond funds have been dropping for four straight months. Since the first of the year, the average U.S. Treasury fund lost almost 6 percent in value, according to Lipper Analytical Services. The average fund invested in securities backed by the Government National Mortgage Association (Ginnie Mae) is down more than 3 percent.

That's not what investors bargained for. Many of you bought bond funds as substitutes for certificates of deposit. This was safe money that you didn't want to lose.

Two points about this "safe" money:

* It's not safe -- if by that you mean that you'll never lose any principal. Share prices on bond funds go up and down, always moving in the opposite direction from interest rates. When interest rates fall, as they did almost continuously during the 1980s and early 1990s, the price of the average bond fund goes up. When interest rates rise, however, value of the bond funds declines.

Last year, interest rates fell to their lowest in four decades. Therefore, bond prices stood at unusual highs. Bond funds looked terrific, relative to bank certificates of deposit. But as it turned out, you were buying at a cyclical peak.

* Rising interest rates will increase the current yield of your fund, because your fund manager can now buy bonds that pay a higher interest rate. If you're reinvesting all the interest you earn, those higher rates will eventually make up for the principal you've lost. But how long might you have to wait?

I asked Ibbotson Associates in Chicago to tell me how long bear markets in bonds lasted in the past, and how long it took for investors to recover the money that they lost. We defined a bear market as a loss in value of 5 percent or more, and looked at intermediate-term Treasury bonds with average maturities of five years.

We got two very different results, depending on whether you reinvest the interest or whether you're using that money to live on.

If you reinvest the interest, buy-and-hold works. For these investors, Ibbotson consultant Derek Sasveld found only four bear markets since 1926. Assuming that you bought just prior to a market decline, you'd have recouped in an average of about 17 months. Your shortest wait would have been 10 months, in 1979-1980; your longest wait would have been 25 months in 1958-1960. Stock investors often wait longer than that.

But it's quite another story if you're using the interest to pay your bills. Your principal alone, not counting interest, may not recover for years, even decades.

That's because bond markets don't work the way stock markets do. They run on long cycles instead of short ones. Bond prices rose from 1925 to 1954, then declined until 1982, then rose again.

You cannot keep your principal whole if you buy in a long-term declining trend. Ibbotson's Sasveld found 12 bear markets since 1926 for buyers who did not reinvest interest. Had you bought in June 1954, it would have taken more than 39 years to recoup your capital loss. Had you bought in July 1972, you'd have waited 14 years. In the bear market starting in October 1986, you'd have waited almost five years.

There are two morals here:

First, if you reinvest interest and intend to hold for the long term, don't sell just because the market turned sour. You still have a shot at earning decent returns over a reasonable period of time. For you, buy-and-hold can work.

Second, if you're living on the interest from your bond fund, your principal may be seriously at risk. There's no way of knowing whether another long decline lies ahead or whether bond prices will rise again. For this reason, it's safer to own some stocks along with your bonds, in order to minimize your potential for loss.

Jane Bryant Quinn is a syndicated author. Write her at: Newsweek, 444 Madison Ave., 18th Floor, New York, N.Y. 10022.

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