Short-Term Versus Long-Term Bond Mutual Funds

Everybody wants a higher yield these days--what with money funds and bank CDs paying so little.

But the rush of investors into government-bond mutual funds and other longer-term bond investments in recent weeks looks dangerously similar to what happened in 1986 and 1987.

At that time, high-yield corporate “junk� bond mutual funds were the rage, and money blindly poured in.

By 1989, however, the risk entailed in those high yields came home to roost, as junk borrowers began to default on their bonds in a slowing economy. Many investors saw their junk holdings plunge in value in 1990.

Today, government bond funds are the hot ticket. As short-term investments such as money funds offer yields of 5.5% or less, many investors are eager to snap up the 8% to 9% yields offered on longer-term bond funds that buy “safe� Treasury or Government National Mortgage Assn. (GNMA) securities.

There’s nothing wrong with investing in longer-term securities, as long as you understand the risks.

The problem today may be that many investors are taking more risk than they should in long-term bond funds when bonds of shorter maturities will earn you nearly as much--for a lot less risk. The numbers may surprise you.

How serious is the flood of money heading for bond funds?

* The Mountain View-based Benham Group of mutual funds saw a net inflow of $16 million into its GNMA bond fund in June. That rose to $40 million in July. And by mid-week last week, the net inflow for August was $27 million--a pace that would bring in $54 million for the full month.

* At Vanguard Group mutual funds in Valley Forge, Pa., the net inflow into the Vanguard Bond Market Fund, which buys long-term Treasury and corporate bonds, jumped from $27 million for all of July to $24 million in the first two weeks of August alone.

Extrapolate numbers like those for the 600-some long-term bond mutual funds, and it adds up to a multibillion-dollar juggernaut looking for higher yields.

And much of that money wants GNMA bonds. A GNMA bond is a security backed by mortgages on peoples’ homes. The mortgage payments basically pass through to the bondholders (after servicing fees are deducted).

Because GNMA bond funds own a lot of GNMA securities created in the 1980s, they encompass mortgages carrying some pretty high interest rates.

That means that yields still are high on GNMA bonds and thus GNMA bond funds. The Vanguard GNMA fund, for example, yields about 8.5%; the Benham GNMA fund yields about 8.3%.

In fact, at many fund companies, the GNMA fund is the highest-yielding fund offered, outside of junk bond funds. So as customers swamp fund companies looking for higher yields these days, the sales reps keep reciting product offerings up the yield ladder, until they come to a stop at GNMA funds--and that’s what many investors end up buying.

What’s the trouble with GNMAs? Maybe nothing. But two possible events could cause returns on GNMA funds to disappoint.

First, these are long-term securities--long-term defined as maturing in 10 years or longer. That means the underlying value of the bonds can fall sharply if market interest rates suddenly shoot higher. It’s a simple equation: If a fixed-rate security matures far in the future, it becomes much less attractive to have your money tied up in it if better yields become available elsewhere.

Second, if market interest rates fall rather than rise, GNMAs also can suffer because many homeowners may decide to refinance their mortgages at lower rates. As they pay off the old loans, high-yield GNMA bonds are retired, and GNMA bond funds reinvest in lower-yielding ones. The funds’ yields drop.

The alternative to GNMA funds or other long-term government bond funds is to go with funds that own shorter-term securities--say, corporate, government or municipal bonds maturing in two to seven years. They pay less than GNMAs--the yields are in the 7% to 8% range--but if market interest rates rise, shorter-term bonds don’t lose as much value because investors know they aren’t stuck with them forever.

How does that trade-off work in practice? Take a look at the accompanying chart. It shows annual total returns since 1986 for two Vanguard Group funds: The company’s GNMA fund, which owns bonds maturing in about 10 years on average, and its Short-Term Corporate Bond fund, which owns high-quality corporate bonds maturing in an average of just 2.6 years.

The GNMA fund now yields 8.5% versus 7.4% on the Short-Term fund, so you gain a point in interest by going longer-term. But you have to think about total return--not just your take-home interest but what happens to your $1,000 investment as market interest rates fluctuate. If your investment falls to $900 even though your yield is 10% ($100 a year), your total return is zero for the year.

How the two Vanguard funds stack up:

* In 1986, the GNMA fund barely beat the Short-Term fund in total return, 11.69% to 11.42%.

* In 1987, when interest rates shot higher, the Short-Term fund’s total return was 4.46%; the GNMA fund suffered worse, producing a return of just 2.15%.

* In 1989, as interest rates fell, the GNMA fund had the advantage even as mortgages were paid off. The GNMA fund earned 14.77% versus 11.45% on the Short-Term fund.

* Through July of this year, the advantage goes to the GNMA fund but not by much: 6.36% to 5.71%.

All in all, you certainly would have earned more in the GNMA fund than in the Short-Term fund since 1986. The question is whether the premium was enough to justify the risk that the GNMA market might have gone awry.

Mutual fund tracker Lipper Analytical Services calculates that the average GNMA fund produced a total return of 51.7% in the five years ended last Dec. 31. The average short-term corporate bond fund produced a total return of 47.6% in the same period.

That’s a difference of just 4.1 percentage points over five years. If you consider the greater risk involved in owning the longer-term securities, that little bonus seems to fade mightily in importance.

That’s not to say investors shouldn’t be buying GNMA funds.

If interest rates continue to ease, but not enough to prompt an avalanche of mortgage refinancings, the GNMA funds could be winners for years.

But before you automatically take a GNMA fund over a short-term fund, think about the chance that interest rates might rise again. And think about whether earning one more percentage point in interest per year is enough to compensate for the risk to your principal in the longer-term fund.

At the very least, you may want to consider hedging your bet--splitting your investment between a long-term fund and a short-term fund. That way, no matter what happens on the rate front, you’re covered.

Vanguard and Benham are just two of many bond mutual fund companies. Vanguard can be reached at (800) 662-7447; Benham can be reached at (800) 321-8321.

Are GNMA Funds Worth the Risk? As interest rates fall, investors are pouring money into mutual funds that buy Government National Mortgage Assn.-guaranteed mortgages. The attraction is yields around 8.5%, versus 8% or less on funds that buy shorter-term Treasury or corporate bonds. But are the longer-term GNMA funds worth the risk? Here are total returns on two funds offered by the Vanguard Group of Valley Forge, Pa.: A GNMA fund, and the group’s Short-Term Corporate bond fund:

Total return (interest plus change in price) Year Vanguard GNMA Vanguard Short-Term Bond 1986 11.69% 11.42% 1987 2.15% 4.46% 1988 8.81% 6.95% 1989 14.77% 11.45% 1990 10.32% 9.23% 1991* 6.36% 5.71%

* through July 31

Sources: Vanguard Group, Lipper Analytical Services Inc.