Return of long bond of little help to funds

Your Funds

Your Money

August 14, 2005|By CHARLES JAFFE

THE U.S. Treasury announced Aug. 3 that it will bring back the 30-year bond next year, in a move that is supposed to appeal to investors looking for safe, long-term choices for their money.

But if you use mutual funds to invest in Treasuries, the move isn't all that appealing, because the return of the long bond - which has not seen any new issues since October 2001 - isn't going to do much to goose returns on your funds.

The situation showcases the unusual position that bond fund managers are in and sends a warning to investors to temper expectations in fixed-income funds.

Generally speaking, interest rates are on the rise, although long-term rates have gone up much more slowly than most analysts expected during the year-plus that the Federal Reserve Board has been raising short-term rates.

Three years ago, as rates were falling to their lowest levels in decades, bond funds posted big gains through capital appreciation and trading. This bull market for bond funds had investors seeing double-digit gains in what should have been some very safe, slow-growing fund categories.

When interest rates fall, bond prices rise. As rates dropped to record lows, the value of bonds held by a fund increased. That meant that a fund's yield was shrinking, but it was able to post enormous gains based on the market value of the paper in the portfolio.

Those gains were much bigger than an investor would have expected had yields been the main factor.

Today, yields are again powering bond funds, which is why investors need to temper their expectations.

"The subtle thing that investors may not realize is that right now, because rates have changed directions, managing a bond fund is all about managing the yield on your portfolio," says Jim Peterson of the Schwab Center for Investment Research.

"With rates rising, bond fund managers can't worry about capital gains, because there are none. So they're focused on finding yield, and the long bond gives them another option for trying to do that."

But the long bond isn't going to be much of a fire starter.

By the time new 30-year Treasuries are issued early in 2006, the market most likely will have factored the change in supply into the equation, so there's not likely to be sudden price movements.

Moreover, most bond fund managers are willing to sacrifice the little bits of extra yield they can get from the long bond for the added stability that comes with a five- or 10-year note.

Many managers of core bond funds - who are not limited to sticking with government notes - already are finding yield elsewhere, and ignoring Treasury securities of all durations.

What makes the re-emergence of the long bond intriguing, however, is the potential for inflation.

The yield curve on bonds has been flat, meaning that investors who lock themselves into a longer maturity are not getting paid a whole lot more for that move than someone who invests only in a short-duration note.

Growth in inflation, however, could change the yield curve.

"Inflation would make the long bond more attractive," says Scott Barry, fixed-income analyst for Morningstar Inc. "You could see some managers using it if they expect inflation to increase.

"The alternative is that a lot of people believe the Fed is almost at the end of its increases, so you could see some fund managers who have good in-flows using their new money to make an interest-rate play. If they think rates will remain stable or will go down from here, they'll think the long bond makes sense."

And that's where investors need to look at bond funds differently in today's yield-drives-the-gains environment.

The funds most likely to be able to use the long bond to squeeze just a little bit more out of the market will be issues that are big, with cash rolling in. The new cash means they do not need to wait for older issues to mature, or trade bonds they hold now, to make a long-term play.

For an investor looking to pick a bond fund, therefore, size matters. Bigger - but with low expenses - may well be better in the current environment.

The other lesson in this story is that big news for the bond market doesn't necessarily become big news on the bottom line. Intermediate and long-term funds could be next to feel the impact of the Fed's rate increases, and the reintroduction of the long bond won't stop that from happening.

The heady days of short-term bond funds posting big gains are gone, replaced by managers hoping for something far more modest, yield that is good enough to keep investors happy even if rates rise and the fund's share value shrinks.

Charles Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or at Box 70, Cohasset, MA 02025-0070.

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