Bond Investors Fasten Eyes on Interest Rates

Bond funds hit rocky seas during the first half of the year, and many doubt that they will see smoother sailing in the months ahead.

"It's an uncertain period," says Colette Coffman of Value Line's Mutual Fund Survey in New York.

Total returns for the average corporate bond fund were just 0.5 percent in the second quarter. Year to date, these funds are down almost 1 percent, as are federal government bonds and municipal bonds.

A key reason was that the economy grew much stronger than expected in the year's first two quarters. Investors became concerned that the Federal Reserve might boost interest rates to deter potential rising inflation. So they demanded higher interest rates at once on new bonds, and the price of outstanding bonds fell. Long-term bonds in particular took a beating.

With bond prices beaten down by inflation worries, some analysts say this is a promising time to buy into bond mutual funds.

But many others advise staying on the sidelines.

"The economy has more staying power than most people think," says Tom Poor, manager of Scudder Short Term Bond Fund in Boston. While the Federal Reserve chose not to raise interest rates at its early July meeting, he thinks it will have to in the future - hitting bond prices.

At some point, with or without Fed prodding, economists generally expect the economy to slow down. That could be a problem for investors in high-yield bond funds, which have been among the better performers. Funds investing in these so-called "junk" bonds saw total returns of almost 2 percent in the second quarter. Though a weaker economy allays interest-rate concerns, it spawns credit-risk worries. A slower economy would mean at-risk corporations are more vulnerable - increasing the risk that their bonds will lose value or even go into default.

Some managers, like Mary Miller of the municipal bond department at Baltimore-based T. Rowe Price Investor Services, agree that the economy is likely to slow down. But Ms. Miller doesn't see it happening in the short term. "I don't think we're there yet," she says. "The inflation question has not really been answered yet."

While the economy is in this holding pattern, she says an investor should be more concerned with the duration of a fund's bonds than with the strength of their credit. T. Rowe Price's long-term municipal bond fund has been investing in bonds with a 15- to 20-year maturity range. "When we think the cycle has played itself out, then we'll move to longer-term bonds," Miller says.

Bond market balloons in size

Though hard on investors this year and in 1994, the bond market has been growing at a heady pace, giving fund managers lots of options. In 1978, the United States had $1 trillion of publicly held bonds outstanding. Today it has $8 trillion, according to an analysis by David L. Babson & Co., investment counsel in Cambridge, Mass.

In the 1980s, a period of high interest rates and falling inflation stimulated investor interest in bond mutual funds. Their assets grew from $3 billion in 1970, to $300 billion in 1985, and reached $800 billion just prior to the bond market slump in 1994. Net assets plunged that year.

By the end of May, bond funds held $821 billion in assets. So far this year, though, the net new cash flow has slowed each month.

A wild card: the foreign investor

Mr. Poor at Scudder cautions that the next few months may see fewer bond investors - especially foreign investors. "The biggest wild card is the amount of foreign participation." In the first quarter of 1996, 75 percent of new bonds were purchased by foreigner investors, compared with an average of 20 percent over the last 10 years. But if interest rates rise in Germany and Japan - the two largest foreign investors - buyers in those nations may keep their money at home. "My concern is that we may run into trouble on this as the year goes on," he says.

Indeed, more-daring US investors might want to look overseas, some analysts say. International bond funds posted the best returns of any broad bond category for the second quarter, though still less than 3 percent. "Emerging-market" funds - investing in bonds of developing nations - did particularly well.

Despite the lackluster performance of the year's first half, some bond-fund managers are upbeat about the future. Michael Brilley, who manages the SIT Tax-Free Income and SIT US Government Securities in Minneapolis, two funds rated highly by Morningstar, predicts that interest rates over the next two years will stabilize and not be as volatile as they have been since 1994.

He also cautions against paying too close attention to interest rates. Over many years, government bonds can be very profitable, he says. "The biggest mistake people make is to look at returns over too short a period of time."