In defense of bond funds: why these investments remain easy to love, even as interest rates settle lower and lower

Kiplinger's Personal Finance Magazine, August, 1998 by Steven T. Goldberg

Vanguard Municipal High Yield fund has less risk than the Strong fund of owning bonds whose issuer defaults, because it invests no more than 20% of assets in low-rated bonds. And expenses eat up only 0.2% of assets annually. This may explain why the fund has posted above-average results among all mum-bond funds each of the past five years to June 15. Its 30-day yield: 4.7%.

BONDS BEAT THE BANK

By stretching just a little beyond the safety of a money-market fund, you can pocket extra yield. That's the province of short-term-bond funds. These funds are particularly attractive now because yields on long-term bonds aren't much higher than yields on short-term bonds.

For example, Strong Advantage pays a 30-day yield of 6.3%, yet its weighted average maturity is a mere 0.9 year. Among funds with a weighted average maturity of three years or less, it ranks third in total return over the past five years. But to earn its yield, it invests in mid-to-low-quality bonds, as well as mortgage-backed securities. Jeffrey Koch, 34, has steered this vehicle capably since 1991, but it could encounter a bump or two if the economy slows.

Unlike the Strong fund, Vanguard Short-Term Corporate sticks to high-grade bonds, which gives it very little credit risk, but a lower yield of 6%. The fund has a weighted average maturity of 2.75 years, which means its net asset value will fall a bit when rates rise. Even in the 1994 bear market in bonds the fund's total return was a barely negative -0.08%, compared with -4.8% for the average bond fund.

HIGH YIELDS STILL ABOUND

High-yield (or "junk") bonds have been big winners in the bond market in recent years. That's a good reason for most investors to put a portion of their bond money into a well-run junk-bond fund.

Northeast Investors Trust is a winner. Turned off by the lack of extra yield available on low-grade junk bonds, the father-and-son team of Ernest and Bruce Monrad had 40% of their assets in Treasury bills and short-term, high-yield debt last summer. When the Asian crisis hit in the fall, they scooped up unwanted Brazilian bonds as well as some temporarily cheap U.S. junk bonds. But credit spreads have tightened again, and the Monrads are more defensive than usual. Northeast is the number-one junk fund for the past five years and number six for the past three years to June 15, and delivers above-average returns year in and year out. Its recent 30-day yield: 8.3%.

RELATED ARTICLE: USING THE NUMBERS

Paying the Piper, Year After Year

Annualized returns shown in our tables are profits in your pocket after fund expenses are subtracted, So why show expense ratios? Because these ongoing costs are a guaranteed drag on performance, In bad years, they can make the difference between making money and losing money. And history shows that, over the long haul, funds that charge below-average expenses do better for shareholders than those that charge above-average fees.