New crop of short-term funds may smooth bond market's bumps

After five years of watching stock prices go nowhere but up, investors in that market finally seem to be getting a taste of what a downturn feels like. But bond market investors already know. They've seen prices of long-term bonds fall twice this year. The hardest-hit group, especially in the first downturn last April, has been the people who were in municipal bonds.

These dips have been especially hard on anyone who was unfamiliar with the bond markets and decided to give them them a try through mutual funds, where high yields were advertised prominently, without similarly large warnings about the risks to an investor's principal. Fund investors were dismayed to see the net asset value (NAV) or share price of their funds fall 10 percent or more in a few days, and even though the yields were higher, it was not enough to make up for lost principal.

The latest of these jolts came shortly before the Federal Reserve Board raised the discount rate from 5 to 6 percent Sept. 4. Anticipating that move, and reacting to the falling dollar, the bond market started moving down a few days earlier.

All this has made many investors somewhat market-shy and left them wondering where they should go now. For some, one answer seems to be short-term debt. Many run-of-the-mill municipal bond funds, for example, own a portfolio of bonds with maturities as great as 20 years. Now, there's a new crop of short- and intermediate-term muni funds with an average maturity of three to five years.

``A lot of companies have funds with shorter maturities now,'' says James Cloonan, president of the American Association of Individual Investors. These include Fidelity, Vanguard, USAA, Babson, and AARP.

One such fund, the Vanguard Limited Term Portfolio, was introduced late in August, as a response to April's bond market decline, and just in time to help investors through the hard days of August and September.

``This was a direct outgrowth of the April debacle,'' says Vanguard vice-president Brian Mattes. By keeping the average maturity in the two- to three-year range, the yield stays about one percentage point under that of a longer-term fund, but less principal would be lost in a bond market decline.

``Historically, one- to three-year debt instruments will have almost the same yield as the long-term ones over 50 years. You'll get the same eventual yield without the roller coaster,'' Mr. Cloonan says.

``Let's assume that long-term rates went from 10 to 11 percent,'' he says (30-year Treasury bills are currently yielding about 9.6 percent). If rates went to 11 percent, a fund with three-year maturities would see its NAV fall 2 percent, while a fund invested in 30-year bonds would lose 8.72 percent of its NAV. Much, if not all, of the 2 percent loss of the shorter-term fund would probably be made up by the higher yield, Cloonan adds.

Vanguard's fund has so far taken in about $14 million, Mr. Mattes figures, much of that from investors who are ``rolling down the yield curve'' from funds where the yields are higher, the maturities are longer, and there's more risk to the principal.

``During periods of rising interest rates and greater volatility, investors have said they don't want to put their principal at risk and have moved in on the yield curve,'' agrees John Haley, portfolio manager of Fidelity's limited-term municipal bond fund. ``This recent level of volatility has been higher than we've seen for quite a while.'' In the first eight months of this year, Mr. Haley says, Fidelity's municipal bond fund had a negative total return of 1.3 percent, while the limited-term fund had a positive total return of 0.81 percent.

Other investors have gone completely defensive and moved into tax-free money market funds, where the yields are only around 4 percent (compared with nearly 8 percent in a long-term fund). But with the money fund's NAV at a constant $1, there's practically no risk of lost principal.

But should investors be spending a lot of effort to move among long-, intermediate-, and short-term bond funds, and in or out of money funds, in an attempt to ``time'' the bond market? Probably not, Cloonan believes.

``You have to take a long-term view,'' he says. If you don't need your money for five, 10, or more years, you might as well stay with the long-term fund. Over time, NAV will maintain an upward course, and the yield will add to your return.

Also, Mattes points out, the vast majority of mutual fund investors reinvest all their dividends, so if a fund is paying an 8 percent yield, 8 percent of your money is buying new fund shares. And while those fund shares are in a decline, reinvestment means you're buying more shares at a cheaper price.

On the other hand, he says, if you'll need your money in a year or two, or ``you don't have the stomach'' for the kind of volatility the bond markets have given investors this year, one of the short- or limited-term bond funds may be a way to smooth out the ride.