Stock market downturn? Bond funds wouldn't mind

Mutual funds

February 09, 1997|By Jerry Morgan | Jerry Morgan,NEWSDAY

It isn't that bond fund managers are defensive these days. But when they say things like, "We're like the Maytag repairman; nobody calls," or, "Did you get second prize and have to write a story on bond funds instead of equities?" you get the sense they feel a tad neglected.

Given the performance of most bond funds the past three years, perhaps some benign neglect was in order. Last year, for example, Treasury bond funds had an average total return of 0.77 percent; general government bond funds, 1.72 percent; Ginnie Mae and mortgage bond funds, less than 4 percent; and general bond funds, 6.05 percent.

Only riskier junk-bond funds, which returned 11.74 percent, and convertible-bond funds at 13.67 percent, did well.

The very risky emerging-market debt funds beat most stock funds, with a 40.7 percent return.

But, since the bond-fund debacle of 1994, investor cash has gone into the rampant bull market for equities.

More than $220 billion went into stock funds in 1996, compared with about $15.8 billion into bond funds. And that $15.8 billion was a big turnaround from the $4.8 billion outflow in 1995 and the $43 billion rout in 1994.

Now, as the stock market boom seems to continue, despite some recent volatility, "investors are pouring money into equity index funds," said Kathleen Gaffney, assistant portfolio manager of the Loomis Sayles Bond Fund, "which leaves bonds much neglected and underloved, which probably means they are a good buying opportunity."

"Money always seems to run in one direction and that is the stock market now; maybe it will turn around soon and go in the other direction," said John Holliday, a bond-fund manager at Wardell & Reed in Overland Park, Kan.

But what bond-fund managers are not-so-secretly hoping for is a downturn in the stock market to help their funds recover.

"What you need is something that happens beneficially to bonds, but less beneficially to stocks," said Ian MacKinnon, director of fixed-income investments for the Vanguard Group. "My attitude is that the stock market has gotten far ahead of

itself, and it is a serious possibility it will be down for the year."

Les Nanberg, MacKinnon's counterpart at Massachusetts Financial Services in Boston, doesn't go that far. "Our official position is that stocks will earn about 10 percent this year, about the same as the high-yield [junk] bond funds," he said.

"I'm not an equity person and not particularly negative on equities, but I don't think they will do another 20 percent this year."

The huge gains of stock funds over the last two years, well over 60 percent compounded as measured by the Standard & Poor's 500 index, might also lead investors to take another look at the allocation of assets in their portfolios, which may be heavier in equities than they intended. At least bond fund managers hope they will.

"We just sent a letter to the shareholders of our bond funds, who are also in equities, saying maybe this would be a good time to rebalance your asset allocation and go into our tax-free funds," -- said Lacy Herrmann, president of Acquila Management in New York.

"Maybe they should cash in chips now. The 25 to 30 percent returns of the last two years are way out of the norm and nothing grows to the sky," Herrmann said. "I don't think there will be a decline of 35 percent, but maybe the stock market will go sideways for a while."

With bond rates trading in a narrow range, there may be little room for many corporate and government bonds to return more than the coupon, or interest, rates, bond-fund managers said. Loomis Sayles' Gaffney said the total return on the fund could grow but she doesn't believe interest rates will drop enough to create a large total return. The price of an existing bond will rise if market rates drop below the bond's coupon rate; the price falls as rates rise above it.

For example, a 7 percent bond with a 15-year maturity would drop to 97.75 percent of its face amount if interest rates rose to 7.25 percent, but would rise to 102.37 percent of its face value if rates declined to 6.5 percent.

For those who are considering bond funds, but know only stock funds, a caution about so-called fixed-income funds: The reasons you buy a bond are not the reasons to buy a bond fund.

A bond promises a fixed interest rate, fixed maturity and guaranteed return of your principal, barring default. Bond funds, however, do not guarantee return of your principal, as many who jumped into bond funds found out when interest rates fell from 1991 to 1993.

There is no fixed income, since the income will vary with the mix of securities in the portfolio and the level of interest rates, and there is no guaranteed maturity because a bond fund has a hypothetically endless life.

What you get, however, is professional management. That means the manager picks the right bonds or mix of bonds. You also get liquidity, which allows you to sell shares more easily than you can sell an individual bond, and the possibility of a higher total return.

All this comes at a price, of course, and since the primary income from a fund is from the bonds' interest, the expenses of the fund can drive your return down.

It is why many financial planners think it makes no sense to pay a commission to buy a bond fund, especially a government or municipal tax-free load fund, because a front load -- a commission paid upfront -- can wipe out the first year's return. If it has a rear load, which is paid when you sell, the higher expenses will act as a drag on the returns.

So know what you are buying when you buy into a bond fund. And that "is shares in a company that owns a portfolio of bonds," said Michael Lipper, who heads Lipper Analytical Services Inc., which tracks fund performance.

Pub Date: 2/09/97

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