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Bonds rewards come with risk

The stampede into bond funds is on once again as investors flee the recent carnage in the stock market.

But not all mutual funds that invest in bonds are created equal, and bonds carry risks, including the potential for losses whenever the Federal Reserve next raises interest rates.

With many stock funds down more than 25 percent in the past two months alone _ even after Wednesday's big rally _ and most bond funds posting gains, it is easy to understand why investors are turning to the seeming safety of bond funds. Still, some caution is in order.

"Investors now can see the risks in owning equities, but they also need to consider the risks and rewards in owning bonds," says John Hollyer, a portfolio manager on several of Vanguard Group's fixed-income funds.

The stream of money into bond funds over the first five months of the year has became a flood. Bond funds took in a net $18-billion during June, while investors pulled $13.8-billion out of stock funds, according to estimates from fund tracker Lipper Inc. That trend probably accelerated in July.

For some investors, the switch out of stocks into bonds may have been necessary to preserve money needed in the short term. But experts caution against overreacting.

For starters, there's the issue of timing. Bond funds delivered strong returns over the past few years as interest rates dropped; bond prices move in the opposite direction as interest rates. But many financial professionals note that interest rates now are at extremely low levels. Whenever rates start to rise, outstanding bonds will decline in value and bond funds may end up with periods of negative total returns.

Investors don't have to go back too far for the last time this happened. When interest rates rose in 1999, the average long-term government bond fund lost 5.7 percent.

"It's pretty late to be making the shift to bonds from stocks," says Don Cassidy, senior research analyst at Lipper Inc. "It's a scary time, but doing what will make you feel comfortable may not be to your financial advantage."

Additionally, just as within the world of stock funds, there are critical differences among the different types of bond funds and the risks they carry. Here's a look at the potential risks and rewards of various bond sectors:

Government-bond funds. Long-term government-bond funds have been a big beneficiary of the recent "flight to quality," as nervous investors have sought the safety of U.S. Treasury bonds. The average long-term government-bond fund is up 5.8 percent this year and an average of 7.8 percent a year over the past three years, Morningstar Inc. says.

But the government-bond "bull market is very, very aged," says Paul McCulley, an economist and portfolio manager with Pacific Investment Management Co., known as Pimco. That suggests future "returns on Treasurys are simply not going to be anything to write home about."

When interest rates go up, long-term bonds are likely to suffer the most, as they did in 1999, because the price volatility of bonds increases with their maturity. A better bet these days is intermediate-term bond funds. The difference in yield isn't great, but the vulnerability to price declines is much less.

Indeed, intermediate bond funds have been one of the most popular destinations for investor cash. The average intermediate fund is up 3.4 percent so far in 2002 and an average of 7 percent a year over the past three years.

Mortgage-backed bonds. Though little noticed by most investors, the market for mortgage-backed bonds is huge, accounting for about 45 percent of the total bond market, says Jeffrey E. Gundlach, manager of two TCW Galileo bond funds. "Everyone who buys a diversified bond fund already has a lot of mortgages; they may not know it," Gundlach says.

There are also funds that specialize in mortgage-backed bonds, such as the top-performing Vanguard GNMA Fund. The attraction these days of mortgage-backed funds, which have taken in $4.6-billion this year and $1.5-billion in June alone, is their substantially higher yields. The yield on Vanguard GNMA this week stood near 5.6 percent, compared with a 4.2 percent yield on Vanguard Intermediate-Term U.S. Treasury Fund.

However, Vanguard's Hollyer cautions that "the extra yield is not a free lunch." Should long-term interest rates drop, taking mortgage rates down with them, the yield on the fund could "decline drastically," Hollyer says. That's because lower mortgage rates could result in a big spike in refinancings among the pool of mortgages that back the bonds.

The average mortgage-backed bond fund has provided investors a 5.3 percent return so far this year, according to Morningstar.

Corporate bonds. Funds that specialize in corporate bonds hauled in $2.2-billion from investors in the first half of the year, according to Lipper, but those investors haven't been handsomely rewarded. The average general corporate bond fund is up 2.2 percent so far this year, according to Morningstar, making it one of the least-rewarding corners of the bond universe. Still, it's better than the 6 percent loss suffered by investors in the average high-yield fund, investing in below-investment-grade or "junk" obligations.

The same woes bedeviling the stock market are crippling the corporate bond market. "If you have stocks and bonds in a portfolio and are thinking of bonds as a way to diversify away from stocks . . . more corporate credit risk may not be the way to go," Vanguard's Hollyer says.

Still, for those willing to take some risk in their bond portfolio, "a year or two from now this could turn out to have been a pretty good opportunity" for buying corporate bonds, says Alison Granger, a bond-fund manager at Hartford Funds. As a result of turmoil in the corporate debt market, yields on corporate bonds exceed those on Treasurys by a wider margin than usual. "But there could still be some really ugly days between here and the bottom _ we just don't know," Granger says.

Short-term bonds. The temptation for nervous investors may be to shove their savings into cash, if not under the mattress. But yields on money-market funds are hovering at 30-year lows, about 1.28 percent, according to iMoneyNet Inc., which tracks those funds.

The next best bet for risk-averse investors may be ultra-short-term bond funds, which these days are yielding about one percentage point more than money-market funds. When interest rates rise, these bond funds will be hit far less than long-term bond funds, since fund managers can quickly replace older, lower-interest bonds with newer, higher-interest issues. Short-term bond funds offer a little more yield, but also a little more interest-rate risk.

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