All of a sudden, investing in the federal government doesn't seem like such a bad idea.
Or, at least, investing in Uncle Sam's IOUs.
With global stock markets in turmoil, individual investors who had shunned U.S. government bond mutual funds in recent years--pulling a net $13.1 billion out of these portfolios in 1996 and 1997--have done an about-face in 1998.
Through the end of June, investors plowed a net $622 million into government bond funds. They've been rewarded with average total returns of 3.4% to 7.2% thus far this year (depending on the specific type of fund), thanks to interest earnings and appreciating bond values as market yields have tumbled.
By contrast, the typical domestic stock fund now is up just 2.5% year to date, in the wake of Wall Street's steep slide in recent months.
No wonder that Trimtabs.com, a Santa Rosa research firm, projects an additional net $1.6 billion will flow into government bond funds in August alone.
"What's going on around the world is phenomenal," notes Jim Gammon, president of Lebenthal Asset Management in New York City. "Everybody is running for safety."
But just how safe are government bond mutual funds? And how can you tell which ones are risky and which aren't?
To answer that, a brief discussion of risk is in order.
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U.S. government bonds--Treasury securities and other government agency bonds--are considered relatively safe by both foreign and domestic investors because they aren't subject to something called "credit risk."
That is to say, although a company that issues debt can end up in bankruptcy--and smaller foreign countries may have difficulties meeting debt payments--the chances of the federal government doing so are nil.
However, that's not to say that government bonds are risk-free.
In 1994, for instance, when market interest rates shot up as the Federal Reserve tightened credit repeatedly, the typical government bond fund posted a negative return of 3.5% for the year--despite earning more than 6% in interest.
What happened?
A fixed-rate bond's price moves in the opposite direction of market interest rates. When rates rise, the price of older bonds that carry lower fixed yields falls.
And when market rates fall--as they have this year--older bonds rise in value because their yields are better than what investors can find in new bonds.
A bond's (or bond fund's) "total return," therefore, reflects both interest earnings and any change in principal value of the security itself resulting from market rate moves.
So there is risk to owning even a U.S. Treasury bond fund.
But there are ways to minimize one's exposure to this so-called interest rate risk.
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Here are five things bond fund managers say safety-minded investors ought to consider before purchasing a government bond portfolio, either through a company-sponsored 401(k) retirement savings plan or in a taxable account:
* What does the fund own? "Not all government bond funds are created equal," says Greg Schultz, a principal with Asset Allocation Advisors in Walnut Creek, Calif. "So when you're talking about bond funds, you've got to be leery of the games that mutual fund companies play."
Whereas some government bond funds invest strictly in U.S. Treasuries, others load up on mortgage-backed securities to boost returns.
Unlike the benchmark 30-year Treasury bond, which is yielding just 5.46% today, some mortgage-backed bonds issued by Fannie Mae, Freddie Mac or Ginnie Mae are yielding twice or even three times as much.
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That income may boost short-term returns, Shultz notes, but it adds an additional component of risk to the overall portfolio.
When market interest rates fall, for instance, the value of mortgage-backed securities also will fall, because a drop in rates will likely lead to another round of mortgage refinancings.
That can hurt a government bond fund's performance if money from mortgage bonds that are paid ahead of schedule must be reinvested at lower rates.
"If even half of your fund is invested in 8% or 9% mortgage-backed bonds, you're going to be subject to tremendous prepayment risk," says Loomis Sayles managing director Kent Newmark, who oversees the firm's fixed-income assets.
Ned Notzon, a managing director at T. Rowe Price Associates, says safety-minded investors who are drawn to government bonds for safety ought to consider a bond fund that invests almost entirely in U.S. Treasuries.
That would include funds like Vanguard's Fixed-Income Intermediate-Term U.S. Treasury Portfolio, which has delivered annualized returns of 7.5% over the past three years through July 31 (no load; minimum initial investment: $3,000; [800] 662-7447); and the American Century-Benham Target Maturities Trust series (no load; minimum initial investment: $2,500; [800] 345-2021).
* Is it a short-term, intermediate-term, or long-term government bond fund? Historically, long-term government bonds have delivered annualized total returns of 5.6%, vs. 5.4% for intermediate-term bonds and 3.8% for Treasury bills.
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