Mutual fund review: Coping with a turn in the bond market

Investors who thought they couldn’t lose money in bond mutual funds got a wake-up call last quarter.

Rising longer-term interest rates meant lower market values for existing fixed-income securities, triggering widespread declines in bond fund share prices.

That produced the first notable losses for many bond investments since the fourth quarter of 2008, when most financial markets were in meltdown mode.

But the losses last quarter were heaviest in funds that owned the longest-term bonds and tax-free municipal issues.

By contrast, the most popular diversified bond funds had modest negative “total returns� of 0.5% to 2% in the three months ended Dec. 31. Total return measures the change in a fund’s share price plus any interest or dividend income earned.

Even if they lost money in the quarter, most bond funds were comfortably in the black with positive total returns for the full year. So people who’ve been invested in the funds since 2009 or before are still in the money.

For example, the T. Rowe Price New Income fund, which owns a mix of government, corporate and mortgage bonds, was up 7.2% for the year despite losing 1% in the quarter.

The point is that investors shouldn’t feel rushed if they’re pondering whether to make changes in their bond-fund lineup, analysts say. “The first thing is: Try not to panic,� said Eric Jacobson, a veteran bond-fund analyst at investment research firm Morningstar Inc. in Chicago.

The rise in market interest rates over the last few months was largely fueled by the improving U.S. economy, as consumer spending revived. Another reason for the rate surge: Bond yields simply had fallen too low from May through October as investors and speculators underestimated the economic recovery.

The 10-year Treasury note yield, a benchmark for many other long-term interest rates, plunged from 3.99% in early April to a low of 2.39% in early October. It has since rebounded nearly a full percentage point, to 3.32%.

If you buy the idea that the economic recovery will continue at a decent pace, you have to allow for the possibility that interest rates will rise further. And that makes for straightforward math when it comes to bonds: When market rates go up, existing bonds automatically lose some of their value because their fixed-rate returns are relatively less attractive compared with yields on new bonds.

How much value is lost, on paper, depends on a bond’s terms (its maturity date and interest rate) and how much market rates rise.

Bond owners, however, continue to earn interest on the securities even if their market value declines. And in the case of mutual funds, those interest earnings should eventually rise if the fund can put cash to work in new bonds at higher rates.

Still, bond investors may have to decide how much pain they can bear should interest rates move higher.

“I hate to sound like the rest of the crowd, but we don’t like bonds now,� said Lon Morton, head of investment advisor Morton Capital Management in Calabasas. “It’s been a great run.�

Although the Federal Reserve in early November pledged to ramp up its purchases of Treasury securities by $600 billion through mid-2011 in an effort to restrain long-term rates, the snap-back in bond yields is a reminder that the Fed can’t directly control long rates.

How to cope with the turn in the bond market? Here are three considerations:

Go with shorter-term bonds. Generally, the sooner the maturity date of a bond, the smaller its potential decline in principal value in a rising-rate environment.

That makes sense: The faster you can expect to get your principal back, the faster your money could be invested in a higher-yielding security.

Funds that invest in intermediate-term investment-grade bonds — securities mostly maturing in 3 1/2 to six years — lost 0.8% on average in the fourth quarter as measured by total return, according to Morningstar. By contrast, funds that owned long-term investment-grade securities (issues maturing beyond six years) lost 2.2%.

The trade-off in protecting against bigger principal losses: Shorter-term bonds pay lower interest returns than longer-term issues. But if you own bonds for capital preservation reasons, shorter is better.

Shift bond sectors. Some types of bonds could hold up much better than others if market interest rates continue to rise.

Funds that focus on corporate high-yield “junk� bonds, for example, posted average total returns of 3.5% last quarter. In an improving economy, junk companies’ financial picture also may improve, attracting investors to their bonds.

The Loomis Sayles Bond fund, which can invest across the spectrum of bonds, now has one-third of its assets in junk issues, said co-manager Kathleen Gaffney in Boston. “When you look at the yields relative to Treasuries, and you look at the fundamentals, we think this is still a good place to be,� she said.

Funds that invest in syndicated bank loans also can do well in a rising-rate environment because those loans’ rates adjust higher with market rates. The average bank-loan fund gained 2.9% in the fourth quarter and was up 9.2% for the year, according to Morningstar.

Be mindful of municipal bond risks. Tax-free muni bond funds suffered some of the biggest losses among bond categories last quarter, as muni market yields soared. The funds remain vulnerable to nerve-racking swings.

Funds that own long-term California muni issues lost 5.8% in the quarter, while nationally diversified long-term muni funds fell 5.1%, according to Morningstar.

Jacobson notes that the muni sector is facing powerful head winds. For one thing, of course, many state and local governments are facing enormous budget deficits and have made the easy spending cuts.

Although actual bond defaults by muni issuers are likely to remain relatively rare, investors could drive muni market yields higher if even a few high-profile defaults were to occur, Jacobson said.

Another issue is that Wall Street brokerages no longer provide the kind of “market-making� in muni securities that they did a few years ago. The lack of liquidity in the market makes bond prices prone to wilder swings — which is exactly what happened last quarter as interest rates began to rise.

“It’s almost inevitable that the muni market is going to be very volatile� in 2011, Jacobson said.

But that also means opportunity for investors who believe that tax-free yields already are high enough to compensate for that volatility and for the risk that rates continue to rise.

James Raspe, a 45-year-old investor in Huntington Beach, has about half of his non-retirement-account money in the Vanguard California Intermediate-Term Tax-Exempt fund. Although he said he was surprised by the portfolio’s 4.1% drop last quarter, he’s thinking of adding money to the fund to generate more tax-free interest earnings.

Also, Raspe said he still believes bonds are less likely to suffer the kind of losses that could hit stocks if the economy were to tank. “I feel more secure in bonds as I’m getting older,� he said.

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