Beware spread between bond yields, returns

Your Funds

Dollars & Sense

October 20, 2002|By CHARLES JAFFE

IN AN UNUSUAL phenomenon, the total return on fixed-income mutual funds is stomping the average yield on the bonds those funds own.

If you invest in an intermediate Treasury note today, your yield will be significantly less than 4 percent. Yet the total return on the average intermediate Treasury mutual fund over the past year is 12 percent.

Pick virtually any category of bond and the story is the same: big gains for bond funds despite small yields on the bonds they own. The discrepancy is so big that it can't possibly continue for long.

To see why the spread between yields and total returns is a warning sign - and to plot appropriate investment strategy going forward - we need to delve into how bonds and bond funds work.

As a rule, bond funds invest in specific types of bonds and can be expected to generate long-term returns roughly equal to what those bonds generate, minus expenses. A good forecasting tool for a bond fund's potential is its 30-day yield, which essentially turns the fund's income from the past 30 days into an annualized projection.

For example, the Fidelity Government Income fund has a 30-day yield of 3.53 percent, meaning its holdings are expected to generate that much income in a year. Year-to-date, however, the fund is up more than 10 percent.

How can that be? The difference is created by day-to-day price fluctuations of the underlying bonds held by the fund.

When interest rates fall - and they are at their lowest level in decades - bond prices rise. Mutual funds calculate their net asset value, or share price, by determining what their holdings would be worth if they were sold at the end of each day. Bloated bond prices push a fund's net asset value up, increasing its total return. (Total return measures income plus share-price appreciation.) The problem is that the capital gains a bond fund accrues today lower its earnings potential.

"What is really devilish about bond funds is that when they have a high return and it comes from a capital gain, it reduces the go-forward potential of the fund," says Jeffrey E. Gundlach, who manages $40 billion in fixed-income assets for Los Angles-based TCW Group Inc. and runs the high-flying TCW Galileo Total Return Bond Fund. "There is a limit in how low yields can go and how high bond prices can go."

With that in mind, projected bond fund returns looked much better a year or two ago than they do today.

"Total return is a poor indicator of future performance [in bond funds], and it creates a very misleading trend," says Loomis Sayles vice chairman Dan Fuss, who manages a number of bond funds. "You feel good for a while, because the price of the bonds gets marked up as the interest rates fall, but eventually the return on a bond fund comes from the income stream on the bonds. ... Bond fund returns that are two or three times what the bonds earn just can't be sustained."

The bill for today's high total return will come due when interest rates rise. That will cut into bond prices, which will drop fund share prices. If the price decline can't be overcome by increased income made on bonds, total return will fall and could become negative. At that point, a bond fund would be losing money while the interest rates rose on the bonds it held.

That's what happened in 1994, when bond funds were coming off three years of falling interest rates and rising total returns. The investing public expected the trend to continue, only to get hammered in 1994, when rates changed direction.

No one knows when rates will turn this time. Some industry watchers think the current rate trend could continue for up to two years.

Others foresee a rate increase early next year.

Either way, the piper will be paid. The concern is that many investors will have followed the siren song of inflated returns, rushing into bond funds just before they crash. It would be the bond fund equivalent of the technology bust, when investors flocked to aggressive funds in 1999, only to get ambushed by the bear market.

It all adds up to a less-than-rosy long-term outlook.

That shouldn't scare investors away, particularly if bond funds are being purchased for diversification and asset allocation purposes. But it should be a warning to keep profit expectations in check, with long-term projections more in line with a fund's 30-day yield than with its gains over the past year or two.

"There is no such thing as a growth bond fund," Fuss says. "It's all about the income and investors who think bond funds will replace the growth they once had in stocks are being fooled by the numbers."

Charles A. Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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