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.”