May 28, 2002 — With yields on money funds hovering around 1.5%, some investors are tempted to consider replacing their money-fund investments with short-to-intermediate high-grade bond funds as “higher-yielding” substitutes. Standard & Poor’s recently completed research suggesting that such investors should be aware of the risks.

The report reinforces the concept that, while short- to intermediate-term bond funds may represent good investment opportunities, all bond funds present an investor with greater risk of losing principal than do money-market funds. Unlike a money-market fund, whose primary goal is to preserve the principal value of an investment, a bond fund seeks higher returns and is thus subject to higher “market price” risk, which means an investor has the possibility of losing invested capital.

The study on bond fund volatility and money-market fund performance was issued by Gary R. Arne, Standard & Poor’s managing director and chief quality officer, and Katherine Gallagher, senior research assistant. It addresses the concerns of individuals and portfolio managers with near-term liquidity needs — especially those with holding periods of less than one year, or those who require absolute principal stability from their fixed-income investments.

This research focused on the annual returns and the volatility of U.S. government bond fund indices and taxable money market funds in the years 2001 and 1999.

“In general,” writes Arne, “investment grade bond portfolios with longer durations are more responsive to interest rate changes than shorter duration portfolios. For small, parallel upward or downward shifts in rates, a fixed-income portfolio will lose or gain a percentage of its market value that is about equal to its duration.” (Duration is a price-sensitivity measure used for bonds. If rates were to rise by 0.5% — or 50 basis points — a fixed-income portfolio with a duration of two years would lose about 1% of its value.)

“While (Federal Reserve) rate cuts helped to push up prices and total returns for intermediate-term bonds last year,” writes Arne, “this year’s expected rate hikes could negatively impact prices and returns for intermediate- to longer-term bonds. Historical evidence has demonstrated that longer-term, investment-grade bond portfolios are more volatile in both rising and falling interest rate environments.”

Historically, longer-term investment-grade bond portfolios outperform short-duration bond funds, but are more volatile in changing interest rate environments than shorter-duration portfolios, notes Arne. But short-term bond funds can also exhibit volatility of returns and price declines, he adds, due mainly to changes in interest rates. Comparing the 1999 & 2001 returns of short-to-intermediate government indices clearly demonstrates the significance of the volatility of returns for individual annual periods. In 2001, the Fed cut interest rates 11 times, totaling 475 basis points (or 4.75%), reducing short-term bond yields and pushing up the prices for higher-coupon, shorter-term, fixed income securities. As a result of the Fed funds rate cuts, prices for bonds on the short-to-intermediate end of the yield curve increased, resulting in higher total returns (interest plus price appreciation) for short-to-intermediate bond funds.

Intermediate high-quality bond funds were the top performers in 2001, gaining 7.16%. Unlike 2001 however, in 1999 the Fed raised borrowing rates three times, which reduced long-term bond returns, resulting in losses for most longer-term fixed-income investments. As for this year, in the first quarter of 2002, bond fund returns have been weak, with the benchmark Salomon Government 10+ index down 2.94%, the Salomon 7-10 year down 1.18%, the Salomon 3-7 year down 0.99%, and the Salomon 1-3 year index down the least at -0.23%.

Looking at annual returns for money funds, Arne notes that, except for the year 2000 and the second half of 2001, yields have consistently ranged between 4% and 5%. Moreover, this “performance” has come with relatively no risk of principal, since U.S. money-market funds are required by SEC guidelines to maintain a very low risk profile, investing mainly in the highest rated short-term debt and maintaining an average maturity of 90 days or less. While yields on money market funds change as interest rates change on short-term investments, their share price is generally not very likely to fluctuate from the $1.00 per share, which means the invested principal is not likely to lose value.

With the U.S. economy on the way to recovery, most economists expect the Fed to raise rates between 100 and 125 basis points (1.00% to 1.25%), perhaps by sometime this summer, notes Arne. While rate cuts helped to push up the prices and total returns for intermediate-term bonds in 2001, this year’s expected rate hikes could cause price declines and diminished returns for shorter-term bond funds, he predicts. Although these types of bond funds usually outperform money market funds, there is no certainty of this on a year-to-year basis, as can be seen by looking back at the events of 1999 and 2001. If short-term rates increase over the next several months, yields on money-market funds will no doubt also increase, says Arne.

While it is difficult to predict interest rate movements, investors can check out a bond fund’s average duration, or sensitivity to rate changes — the lower it is, the less sensitive it will be to rate changes. Knowing a fund’s duration, says Arne, an investor can make a more informed decision about the risks and rewards of investing in long-term bonds or bond funds when seeking higher yields.