Bonds may rebound

NEW YORK – Investors who have grown accustomed to an environment of rising interest rates will want to think about adjusting their strategies when the Federal Reserve takes a break from further rate increases.

Bond mutual funds, which pool investments to buy thousands of individual bonds, have done poorly as the Federal Reserve raised interest rates; the reason is that bonds’ prices fall as their yields rise and investors have kept their distance. But with rates expected to stabilize, that trend is likely to change.

“For 12 months or so, bond funds have struggled to break even,” said Scott Berry, an analyst with mutual fund research firm Morningstar. “The Fed’s pausing could stop the bleeding.”

The Fed’s policy-making Open Market Committee began what it called “measured” rate increases in June 2004, using 16 quarter-percentage-point bumps to push the country’s benchmark short-term rate to 5 percent, its highest level in five years, from an all-time low of 1 percent.

“The initial hikes didn’t have a huge impact on the bond market,” Berry said, “But that changed last year.”

Data compiled by researcher Lipper Inc. backs that up: The average taxable bond fund return has been 2.41 percent since May 2005, down from 5.10 percent over five years. Year-to-date, the performance has been dramatically worse, a slim 0.42 percent return.

As with stock-based mutual funds, bond funds come in a wide variety, and analysts say some will benefit more than others from a pause in rate hikes. Some funds are based on the type of bonds they own, such as municipal, corporate, mortgage-backed or Treasury bonds. Some are also based on the bonds’ duration to maturity – whether they’re short-, intermediate- or long-term bonds.

Duration to maturity determines how susceptible bonds are to interest rate changes; the shorter the duration, for example, the less a bond’s price will move as rates climb. Yields are also generally higher for bonds with longer maturities, as investors are committing their money for a longer time.

But that’s not always the case – for much of the past year, the yield curve, which plots yields against bonds’ time to maturity, has been relatively flat, which means that longer-term bonds haven’t had the yields investors expected. That’s changed recently, and in April, the yield on 10-year government bonds rose above 5 percent for the first time since May 2002; it’s now at about 5.1 percent.

The neophyte bond investor might feel overwhelmed by the possibilities. But Berry’s advice is simple – “when rates are rising, it makes sense to get into shorter-term bond funds,” those holding bonds with maturities less than two years away. Long-term Treasury bonds have performed the worst because they are seen as riskier when rates are rising.

And, Berry said, regardless of the rate environment, investors with short-term investment goals – those who are nearing retirement, or saving for college tuition or a large purchase like a home – should buy shorter-term bond funds because of their lower volatility.