MARLA'S MUSINGS

. . . from the Publisher of Brill's Mutual Funds Interactive^®

The Case For Short-Term Bond Funds

by Marla Brill
Publisher, Brill’s Mutual Funds Interactive

The year 1999 was a resounding clinker for bond funds, with nearly three-quarters of them delivering a negative total return. The downturn left many investors who turn to these funds as a conservative road to steady income, or as a way to balance their portfolios against stock market risk, wondering what went wrong.

The main culprit, of course, was rising interest rates. When interest rates rise, the price of outstanding bonds with lower coupon rates (the annual rate of interest a bond pays) must fall so that they become competitive with new, higher-paying issues. The longer it takes for a bond to mature the greater the price drop will be, since the holder is married to the lower rate for a longer time.

While this basic explanation may draw a resounding "so what?’ from those familiar with bonds and how they work, this site has received numerous e-mails from perplexed investors, as well as queries from newsgroup posters, wondering why their bond fund holdings are worth less than they were a year ago. Maybe they didn’t understand that bonds rise and fall and value as interest rates change, and just focused on getting the highest rate available. Or perhaps their financial advisors or "knowledgeable" friends failed to explain how dramatically prices of long-term bonds, and the funds that invest in them, can fluctuate.

So the message bears repeating: there’s a huge difference between the price fluctuation of bonds that mature in one or two years, versus longer-term securities maturing in 20 years of more. As an example, if interest rates rise from 7 percent to 8 percent, a 7 percent coupon bond with one year remaining to maturity will lose one percent of its principal value. But if a bond with a 7 percent coupon matures in 20 years, its principal value drops by 10 percent under the same scenario.

Of course, longer-term bonds can be stunningly profitable in times of falling interest rates, and rising bond prices. Going back to the previous example, if interest rates declined from 7 percent to 5 percent, an investor holding a bond with a 7 percent coupon with ten years left to maturity would enjoy an increase of 15.5 percent in principal value. A bond with the same coupon but only a year left to maturity would increase in value by only one percent.

Bond funds follow a similar pattern, with those investing in longer maturities experiencing the greatest price swings. In 1999, for example, three Vanguard funds that invest in Treasury issues had vastly different returns in a rising interest rate environment. The Vanguard Long-Term Treasury Fund fell 8.66 percent, and the Vanguard Intermediate-Term Treasury Fund was down 3.52 percent. Only the Vanguard Short-Term Treasury Fund ended the year in positive territory, up 1.85 percent.

An interesting thing is happening now. Usually, long-term bonds yield more than short-term bonds. Today, that’s not the case.

Taking the example of the Vanguard Funds again, the group’s Treasury Money Market Fund had a yield of 5.21 percent on March 1. By going out a bit further on the yield curve to the Short-Term Treasury Fund, which has an average duration of about two years, investors capture an extra 1.3 percent in yield, or 6.5 percent. After that the yield curve flattens out, with the Intermediate-Term Treasury Fund yielding 6.68 percent, just 18 basis points higher than the short-term fund. And the Long-Term Treasury Fund yield is actually lower, at 6.26 percent.

For investors, the spike at the short end of the yield curve means you don’t have to take a whole lot of interest rate risk to get a fairly attractive yield right now. That’s good news for people willing to trade the potential for higher total returns in a falling interest rate environment for less downside risk if interest rates go up.