Bond Rally Story Marked by Plot Twists

The bond market rally has begun to take on the air of a sci-fi movie: It’s “The Thing That Wouldn’t Die.”

On Friday, interest rates fell across the board after the government’s report that wholesale prices were unchanged in May. Inflation worries that have dogged the bond market in recent weeks were quelled with that news.

But many bond pros still can’t shake the feeling that interest rates will be higher by Christmas, assuming the economy continues to expand.

Where there is growing disagreement, however, is over the future shape of the “yield curve.” In other words, do short-term and long-term interest rates rise in tandem from now on, or does one end of the market rise much faster than the other?

The outcome will be much more than academic for the millions of investors in bond mutual funds. Depending on what your fund owns--more shorter-term bonds, or more longer-term ones--you could win big or lose big in the next rate move. So this is a good time to look at what’s in your fund and the manager’s strategy going forward.

Since April, the smart bets have been on higher short-term rates (defined here as three-month to five-year rates) and steady or lower longer-term rates:

* Short-term rates have crept up on the growing belief that the Federal Reserve will be forced to tighten credit soon. Any sign of faster-than-expected economic growth--if accompanied by rising inflation--would give the Fed an excuse to raise short rates, which are near the lowest levels in 30 years.

While Friday’s no-inflation report was a relief, many bond pros still expect strong enough economic growth by year’s end to justify a Fed rate hike. “I think that over the next three to six months, we’re going to see the first move toward a tightening posture by the Fed,” says William Gross, bond strategist at Pacific Investment Management in Newport Beach.

The market seems to think so, too: Though the discount rate on three-month Treasury bills fell to 3.04% Friday from 3.09% Thursday, it remains well above the 1993 low of 2.82% reached in April.

* Longer-term interest rates have continued to fall in recent weeks, even as short rates have risen. At 6.80% Friday, the yield on the Treasury’s 30-year bond was down from 6.87% Thursday and 7.04% in mid-May.

While the Fed controls short-term rates, long rates are essentially set by investors, who judge how high or low a yield to demand based on inflation expectations.

Thus, the Fed’s apparent willingness to fight inflation by raising short rates is actually helping to pull long rates down, experts note.

In bond parlance, the upshot of all this is that the “yield curve” is flattening--which just means that the gulf between long and short rates is finally narrowing.

To illustrate: Late last September, the annualized yield on a two-year Treasury note was 3.79%, while a 30-year T-bond yielded 7.36%. So the yield advantage in buying a 30-year bond was a huge 3.57 percentage points.

Now, the two-year T-note yields 4.12% while the 30-year bond’s yield is 6.80%. So the spread has shrunk to 2.68 points.

The winners so far in this narrowing are investors who have stuck with longer-term bonds. They have collected a higher yield than owners of shorter-term bonds, and they have seen their bonds appreciate in value as long-term rates have come down.

For example, the average long-term, high-quality corporate bond mutual fund produced a total return (yield plus price appreciation) of 5.56% in the first five months of this year, according to fund tracker Lipper Analytical Services.

Meanwhile, the average intermediate-term corporate fund (typically owning bonds in the five- to 10-year range) earned 4.91%, while short-term (under five years) corporate funds earned 3.06% on average.

Is this trend sustainable? If you thought so, you’d obviously want to have more of your money in long-term bonds. In fact, whether they know it or not, the majority of Treasury bond fund investors seem to favor such a strategy, judging by the preponderance of assets in funds that can buy long-term securities.

But many pros caution that there is extreme risk in betting too heavily on long-term bonds at this point.

Philip Barach, manager of Enterprise Government Securities bond fund in Los Angeles, figures that when the Fed officially pushes short-term rates higher, long rates will rise as well. “People in long-term bonds are deluding themselves to think otherwise,” he says.

Tighter Fed credit, Barach notes, would almost certainly stem from a stronger economy, which should put pressure on all rates as demand for money rises.

Other bond experts say it’s quite possible that short rates could be substantially higher by year’s end without a similar rise in long rates.

Robert Barbera, economist at Lehman Bros. in New York, argues that investors have kept long rates so high relative to short rates over the past year mainly because they’ve been expecting short rates to move up eventually. “It won’t be a surprise” when it happens, so long rates can stay steady, he contends.

What’s more, there’s a powerful argument that serious budget-deficit cutting in Washington, plus declining interest rates overseas, could help keep a lid on long rates.

Even so, Barbera warns that anyone owning long-term bonds today must be aware of the risk: Any across-the-board rise in rates will cause long-term bonds to drop in value far faster than shorter-term bonds.

Bond pros use the term “duration” to describe a fixed-rate bond’s sensitivity to changes in market interest rates. Duration takes into account a bond’s yield and its time to mature. Basically, the longer a bond’s duration in years, the greater the impact on its value if market rates rise or fall.

Suppose that both long and short rates rise one percentage point over the next few months:

* A two-year bond that now yields 4.12% would lose 1.7% of its paper value if new two-year bonds are paying 5.12%. That would be a painful loss, but not terminal--and it wouldn’t be a loss at all if you could hold the bond until maturity.

* In contrast, the damage would be far worse to a 30-year bond that now yields 6.80%. If new 30-year bonds yield 7.80%, the older 6.80% bonds would plunge nearly 11% in value--effectively wiping out almost two years’ interest earnings.

Some fund managers, uncertain how rates are likely to play out from here, have chosen a “barbell” portfolio approach: They own a lot of short-term bonds and a lot of long-term bonds but not much in the intermediate-term area.

Bradley Tank, co-manager of the Strong Government Securities fund in Milwaukee, says his fund’s average duration is 4.3 years, with a yield of about 6%. To get that combination, he says, “We’re overweighted in long Treasury bonds, overweighted in short-term mortgage securities and light in the middle (maturities).”

The idea, Tank says, is to balance the payoff from high long-term yields with the relative safety of a lot of short-term paper, which won’t lose much value even if short rates rise further.

A fund manager who wanted to take less risk than Tank might engineer a portfolio with a duration of just two to three years; an extremely aggressive manager might push the fund’s duration to about 10 years.

The point is, if you don’t know your fund’s duration, or its mix of securities, or its game plan, it’s time to ask--to be sure that you’re in the right kind of fund for the risk you’re willing to take.

Tracking Bond Fund Ownership

Most bond fund investors have their money in long-term funds, which can own securities maturing as far in the future as 20 to 30 years (though many own much shorter-term bonds as well).

Here’s a look at bond fund assets, by fund category, as of March 31. Intermediate-term funds generally limit their investments to five-to 10-year bonds; short-term funds stay with bonds under five years in term.

* Bond Fund Assets by Fund Category:

U.S. government and mortgage bonds (including GNMA)

Long-term: 73.6%

Short-term: 21.5%

Intermediate-term: 4.9%

* Corporate bonds (including “junk”)

Long-term: 30.3%

Short-term: 19.1%

Intermediate-term: 50.6%

* Tax-exempt muni bonds

Long-term: 89.6%

Short-term: 3.9%

Intermediate-term: 6.5%

Source: Lipper Analytical Services

What Happens If Rates Change?

Here’s how the principal value of bonds of various maturities would change if interest rates were to rise or fall one percentage point across the board over the next few months.

If market yields If market yields Bond Current RISE 1 pctg. point, FALL 1 pctg. point, maturity yield bond’s value: bond’s value: 2 years 4.12% falls 1.7% rises 1.9% 5 years 5.22% falls 4.3% rises 5.0% 10 years 5.96% falls 6.9% rises 7.5% 30 years 6.80% falls 10.9% rises 13.9%

Source: Strong Funds; yields used are current yields on Treasury bonds