ASSESSING THE INFLATION THREAT : Commodity Hikes No Bond Fund Concern

By all rights, bond mutual fund investors shouldn’t have it this good.

Prices of key commodities have surged this year, which usually means that higher inflation--the scourge of fixed-income investors--is in the pipeline.

But long-term interest rates have been going down even as commodity prices have risen. And that has produced a bonanza for bond fund owners.

The average U.S. government bond mutual fund earned a total return of 6.59% in the first half of the year, a full 2 percentage points above the 4.58% return on the average stock fund, according to fund tracker Lipper Analytical Services in Summit, N.J.

About half the typical government bond fund’s return came from interest earnings; the other half came from share price appreciation, as falling market interest rates boosted the value of older bonds.

Even on Tuesday, as commodity prices rocketed anew, long-term bond yields responded only grudgingly. The yield on the Treasury’s 30-year bond closed at 6.68%, up just slightly from 6.66% on Friday and way down from 7.39% at year’s end.

In theory, anyway, the threat of higher inflation should push interest rates up, to compensate bond owners for the erosion of their fixed returns. Rising rates devalue older bonds, thus producing widespread losses--at least on paper--for bond fund owners.

Yet so far, the bond market doesn’t believe the inflation hype. For one, many bond investors simply don’t expect commodity price hikes to stick.

More important, some bond managers argue, is that there is little inflation where it counts--in labor costs. “You’d have to see wage inflation become a major issue again” for investors to worry, argues Ralph Stellmacher, manager of the Oppenheimer High-Yield bond fund in New York. “We don’t see that.”

So for now, many bond pros are content to predict more of the same in the economy over the next six months: modest growth, low inflation and stable long-term interest rates. In that kind of environment, the same bond fund categories that did best in the first half--high-yield junk corporate bonds, for example, and long-term government bonds--could continue to do well for their shareholders.

But there’s a big unknown in this picture, and that’s the potential effect of rising short-term interest rates. Tuesday, yet another rumor swept Wall Street that the Federal Reserve Board is eager to push short rates slightly higher, for the first time in four years.

The Fed has in fact signaled in recent months that the next move in short rates is likely to be up, as the economy gradually improves. And almost everyone on Wall Street appears to be mentally prepared for short rates to rise from the current 3% range, the lowest in 30 years.

But many bond fund managers are betting that long rates can stay level even as short rates move up. The reasoning is that there’s enough of a premium in long-term bond yields, now at 5% to 8% depending on the type of bond, to keep the market from demanding more, even if short rates rise from 3% to 4%.

Hence, many managers are opting for the “barbell” approach in structuring their bond funds: They’re loading up on longer-term bonds and on very short-term securities, and avoiding the middle ground of one- to five-year securities.

For example, Steven Nothern, senior vice president at the MFS Government Securities fund in Boston, has shifted his portfolio heavily into 10- to 20-year Treasury bonds at one end and into very short-term mortgage securities at the other. Where the portfolio is under-weighted: one- to five-year Treasury securities.

If the Fed pushes short-term rates up, Nothern figures, bonds of middle maturities will be affected most, because investors either will seek the safety of very short-term issues or they’ll rush out the “yield curve” toward the highest-yielding, longest-term bonds.

Other government bond fund managers are hedging by moving out of Treasury securities and into mortgage-backed bonds and other bonds that offer better yields than Treasuries.

Michael Kennedy, manager of the SteinRoe Government Income fund in Chicago, figures mortgage bonds are a good defense against rising rates because if market rates move up, fewer homeowners will choose to pay off their mortgages early. Heavy prepayment rates have caused many investors to shy away from mortgage bonds in recent months, depressing their prices. (That shows up in the limited returns so far this year for GNMA mortgage bond funds.)

What about funds that specifically target middle-term securities? If short-term interest rates rise and push middle-term rates up as well, the damage to the mid-range funds’ principal values may be limited--but not enough to avoid a public relations black eye. After all, many investors have assumed they’re “safe” in mid-range funds.

Truth is, no bond investment will be safe if interest rates rise across the board. “The issue is not the size of the loss, but whether you’re prepared for a loss at all,” says Lipper Analytical’s Michael Lipper.

If you can’t stand the thought of your bond fund losing value, better start planning your escape.

How Bond Funds Fared

Here are average total returns for key categories of bond mutual funds for three periods ended June 30. Total return includes interest earnings plus or minus any change in the bonds’ principal value.

Average total return Fund category 2nd qtr. 6 mos. 12 mos. Junk corporate bonds +4.77% +11.8% +17.4% Global bonds, long-term +3.37 +8.6 +8.9 General muni bonds, long-term +3.37 +7.3 +11.9 Calif. muni bonds, long-term +3.35 +7.6 +12.1 Mixed bonds +3.13 +8.3 +12.9 Lower-quality corporate +3.08 +8.3 +13.8 bonds, long-term High-quality corporate +2.95 +7.8 +12.8 bonds, long-term U.S. govt. bonds, long-term +2.56 +6.6 +11.4 High-quality corporate +2.42 +6.8 +11.4 bonds, 5- to 10-year U.S. govt. bonds, +2.25 +6.1 +10.1 5- to 10-year GNMA bonds +1.91 +5.0 +9.0 Global money market +1.66 +3.3 -0.5 High-quality corporate +1.38 +3.9 +6.9 bonds, 1- to 5-year U.S. govt. bonds, 1- to 5-year +1.38 +4.0 +7.1 Adjustable-rate mortgage bonds +1.09 +2.5 4.4 Money market +0.62 +1.3 +2.7

Source: Lipper Analytical Services Inc.