Bond funds risk a time bomb
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Bond funds risk a time bomb
Kenneth E. Volpert would be the envy of Center City sidewalk vendors if he traded his bond desk at Vanguard Group for a lunch cart.
The smaller the portions that Volpert serves up as manager of the Malvern fund family's Total Bond Market Index fund, the longer the line in front of him becomes. Assets of the fund grew from $16.4 billion at the end of 2000 to $25.2 billion at the end of April, according to Morningstar Inc.
All bond funds are gaining in popularity even while they deliver less income. Investors pulled out money in 2000 when Treasury securities were paying 6.3 percent. This year, they are on pace to stick in $155 billion with government bonds paying 2.9 percent. Bond professionals say that what bonds pay in interest - their yield - is a better indicator of value than the performance results found in mutual-fund listings.
"It's the only market where you reduce what the investor gets going forward, and you get more cash flow," Volpert said. "Go figure."
Investors should do plenty of figuring before buying bond funds at this point, jumping into a market being described in terms reserved for stocks four years ago. Volpert, for one, calls it "a powder keg of risk." At a recent Morningstar conference, "the bond bubble" was the topic of conversation among fund managers, said Eric Jacobson, a senior analyst at the Chicago mutual-fund research firm.
"Almost everyone there felt we were at a much greater risk of rising interest rates" than the opposite scenario, Jacobson said. The fund managers worry that investors are paying too much for bonds, anticipating deflation - falling prices that would drag down the economy and interest rates. The Federal Reserve Board cited deflation last week as it cut interest rates for the 13th time since 2000.
While few economists expect to see the U.S. economy roar back soon, interest rates cannot keep falling as they have without hitting zero. What's more, the Fed could change course abruptly once an economic recovery gathered momentum. In 1994, after a similar period of pessimism, the Fed raised rates six times to slow things down.
Bond investors suffered more than stock investors that year. The Lehman Brothers Aggregate Bond Index lost 2.92 percent to record the worst year for the key index in its 27-year history. The aggregate index tracks government, corporate and mortgage-backed bonds, providing a comprehensive look at bonds. While the economy is different today, Mark Zandi will not rule out the risk of revisiting the 1994 bond trap. "It's a significant possibility," said the chief economist at Economy.com, of West Chester.
John Silvia, chief economist of Wachovia Securities, agreed. "The economy will pick up again," he said. Depending on how quickly, the bond market "could sell off much like it did then." In bonds, as in cheesesteaks, what you get is as important as what you pay. The price of an existing bond rises as interest rates fall to keep its yield in line with lower interest rates.
Investors who covet the 12.7 percent return of the Vanguard Intermediate-Term Treasury Fund over the last 12 months are admiring a combination of price appreciation, or capital gains, and interest income.
The fund's return, through Friday, breaks out as roughly 7.9 percentage points of capital gains and 4.8 percentage points of interest income, according to Vanguard. Mutual funds price their securities each weeknight in order to fill purchase and redemption orders. In the case of bond funds, capital gains are as ephemeral as those of stocks.
Investors who buy the fund today based on its historical performance are betting that interest rates will continue to fall. Instead, the 10-year bond's yield jumped last week to 3.5 percent after the Fed rate cut as investors decided that the economy was healthier than they had thought. The 10-year bond has not been this low since 1958.
Because bond prices fall when interest rates rise, those capital gains promise to turn into capital losses in the years ahead. The math can be grim, as Volpert demonstrated using a formula to predict how prices respond to interest rate increases.
His example is a percentage-point rise in the 10-year Treasury bond yield, to 4.5 percent from 3.5 percent. "If rates go up by that amount, which retraces only a small amount of the recent decline, the price of a 10-year bond would drop by about 8 percentage points," Volpert said. A bond selling for $100 would then be worth $92.
Earning 3.5 percent annually, "it would take nearly three years to get that money back," he said.
Bond managers are loath to bet against the Fed and its powerful chairman.
"Our belief is that, over the long term, Alan Greenspan wins and he succeeds in inflating the economy," said Stephen Scianci, a portfolio manager at Delaware Investments.
The Fed would then shift to fighting inflation by pushing interest rates higher. Scianci said he doubted that the change would be abrupt.
"Our view is that the Fed is on hold because of low growth" and modest inflation, he said. "Rates are going to stay lower longer than people expect." Zandi, the economist, agreed that 1994 was different. "Back then, there was a lot of pent-up demand for cars and houses," he said. "Today, we have spent-up demand."
What's more, professional managers were caught napping in 1994. Expecting low rates to persist, many used derivatives to fatten yields. Bond prices sank faster as these risky bets blew up.
Volpert warned investors against making similar bets. "Don't stretch for yield," he said. "With that additional yield comes a significant risk" increase.
By: Todd Mason
The smaller the portions that Volpert serves up as manager of the Malvern fund family's Total Bond Market Index fund, the longer the line in front of him becomes. Assets of the fund grew from $16.4 billion at the end of 2000 to $25.2 billion at the end of April, according to Morningstar Inc.
All bond funds are gaining in popularity even while they deliver less income. Investors pulled out money in 2000 when Treasury securities were paying 6.3 percent. This year, they are on pace to stick in $155 billion with government bonds paying 2.9 percent. Bond professionals say that what bonds pay in interest - their yield - is a better indicator of value than the performance results found in mutual-fund listings.
"It's the only market where you reduce what the investor gets going forward, and you get more cash flow," Volpert said. "Go figure."
Investors should do plenty of figuring before buying bond funds at this point, jumping into a market being described in terms reserved for stocks four years ago. Volpert, for one, calls it "a powder keg of risk." At a recent Morningstar conference, "the bond bubble" was the topic of conversation among fund managers, said Eric Jacobson, a senior analyst at the Chicago mutual-fund research firm.
"Almost everyone there felt we were at a much greater risk of rising interest rates" than the opposite scenario, Jacobson said. The fund managers worry that investors are paying too much for bonds, anticipating deflation - falling prices that would drag down the economy and interest rates. The Federal Reserve Board cited deflation last week as it cut interest rates for the 13th time since 2000.
While few economists expect to see the U.S. economy roar back soon, interest rates cannot keep falling as they have without hitting zero. What's more, the Fed could change course abruptly once an economic recovery gathered momentum. In 1994, after a similar period of pessimism, the Fed raised rates six times to slow things down.
Bond investors suffered more than stock investors that year. The Lehman Brothers Aggregate Bond Index lost 2.92 percent to record the worst year for the key index in its 27-year history. The aggregate index tracks government, corporate and mortgage-backed bonds, providing a comprehensive look at bonds. While the economy is different today, Mark Zandi will not rule out the risk of revisiting the 1994 bond trap. "It's a significant possibility," said the chief economist at Economy.com, of West Chester.
John Silvia, chief economist of Wachovia Securities, agreed. "The economy will pick up again," he said. Depending on how quickly, the bond market "could sell off much like it did then." In bonds, as in cheesesteaks, what you get is as important as what you pay. The price of an existing bond rises as interest rates fall to keep its yield in line with lower interest rates.
Investors who covet the 12.7 percent return of the Vanguard Intermediate-Term Treasury Fund over the last 12 months are admiring a combination of price appreciation, or capital gains, and interest income.
The fund's return, through Friday, breaks out as roughly 7.9 percentage points of capital gains and 4.8 percentage points of interest income, according to Vanguard. Mutual funds price their securities each weeknight in order to fill purchase and redemption orders. In the case of bond funds, capital gains are as ephemeral as those of stocks.
Investors who buy the fund today based on its historical performance are betting that interest rates will continue to fall. Instead, the 10-year bond's yield jumped last week to 3.5 percent after the Fed rate cut as investors decided that the economy was healthier than they had thought. The 10-year bond has not been this low since 1958.
Because bond prices fall when interest rates rise, those capital gains promise to turn into capital losses in the years ahead. The math can be grim, as Volpert demonstrated using a formula to predict how prices respond to interest rate increases.
His example is a percentage-point rise in the 10-year Treasury bond yield, to 4.5 percent from 3.5 percent. "If rates go up by that amount, which retraces only a small amount of the recent decline, the price of a 10-year bond would drop by about 8 percentage points," Volpert said. A bond selling for $100 would then be worth $92.
Earning 3.5 percent annually, "it would take nearly three years to get that money back," he said.
Bond managers are loath to bet against the Fed and its powerful chairman.
"Our belief is that, over the long term, Alan Greenspan wins and he succeeds in inflating the economy," said Stephen Scianci, a portfolio manager at Delaware Investments.
The Fed would then shift to fighting inflation by pushing interest rates higher. Scianci said he doubted that the change would be abrupt.
"Our view is that the Fed is on hold because of low growth" and modest inflation, he said. "Rates are going to stay lower longer than people expect." Zandi, the economist, agreed that 1994 was different. "Back then, there was a lot of pent-up demand for cars and houses," he said. "Today, we have spent-up demand."
What's more, professional managers were caught napping in 1994. Expecting low rates to persist, many used derivatives to fatten yields. Bond prices sank faster as these risky bets blew up.
Volpert warned investors against making similar bets. "Don't stretch for yield," he said. "With that additional yield comes a significant risk" increase.
By: Todd Mason
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