Lipper Research Senior Analyst Don Cassidy on "Business for Breakfast" 1060 KRCN - Bond Funds for a Change?

A. Sure. And with the recent slide in stocks since early January, maybesome people are thinking about being more cautious on where their money is.

Q. Right. But of course there is that problem about bond prices dropping ifinterest rates rise!

A. Yes, and investors need to look at ways to guard against that, if theyare going to buy bonds or bond funds, I think.

Q. Is that really true? I mean, suppose someone intends to buy and hold"forever"?

A. A couple of points on that: first, people may intend to hold for thelong term, but things happen...unexpected expenses, illnesses, settling anestate, etc. And even with the best of long term-holding intentions,sometimes people will panic and sell near the bottom, if their bonds orbond funds go down.

Q. You mentioned "bonds or bond funds"--is there any important differencethere, for investors?

A. Definitely! Bonds mature at a given date. A bond mutual fund, unless itis one of the few structured as a term trust, never "matures." A long-termbond fund will own newer long-term bonds in 25 years, and rates might be upso its NAV would be down. But of course you take selection andliquidity/spread risk if you buy individual bonds.

Q. So, okay, what options does a bond fund investor have to guard againstbeing hurt if long rates rise?

A. Let me list a few, and then we can circle back and discuss...

• Buy a "laddered" bond fund.
• Avoid the long-term bond funds in favor ofshort/intermediate-term bond funds.
• Buy Treasury inflation-protected bond funds or the "TIP" ETF.
• Own some inverse bond funds to hedge your long-bond price risk.
• Buy one of the several bond ETFs to get lower costs than with aconventional bond fund.
• Learn about loan participation or "bank loan" funds.
• Consider closed-end bond funds, which presently trade at average discounts of about 4% to full value.

Q. Wow, quite a list of options! Let's start from the top...

A. Sure. A "laddered" fund is not focused on a single maturity range likelong- or short-term bonds are. It owns some bonds at all maturity ranges,so its NAV is less sensitive to rate changes than that of a fund with alllong bonds. The yield usually is lower, since it does not own all longbonds. In the present flat-curve situation the yield might not be muchlower, and yet it still protects against major downside.

Q. And if you want to avoid the long-term bonds altogether?

A. You will avoid the greater downside price risk if rates should rise. Ofcourse, existing laddered or shorter-term funds will have some bonds theybought when rates were lower, so the net yield probably will be lower evennow, unless you buy a new fund.

Q. How about those TIPS bond funds?

A. They have gotten quite a following. They currently have about $38billion in them, which is twice as much as utility funds and just a fewbillion less than natural resources funds. The attraction here is that thebonds they hold are variable-rate paper. So, if inflation rises, yourinterest rate is bumped up in the form of indexed principal. They are notvery tax-efficient in taxable accounts though. But with current totalyields here being above what you'd get on a straight long-Treasury bond orfund, they seem like a good middle bet, with the main risk being that youmiss appreciation if long yields fall. So, you need to think about yourexpectations and strategy.

Q. And, you said inverse bond funds?

A. Right. These pay no interest. They're designed to have their price movethe opposite direction of prices of long-term bonds. So, you could use themas a hedge, or if you are aggressive you could use them to actually bet onrising rates.

Q. And the bond ETFs?

A. There are very few of them. You can be long or short. But if you areshort, you pay the interest! The long-term one is TLT for long Treasuries.There is a medium-term corporates one with a ticker of LQD. You get moreyield with less absolute quality than in UST bonds, of course. And there isa short-term governments fund with the ticker SHY.

Q. What are the advantages of ETFs versus old-fashioned bond funds, then?

A. Lower expense ratios (which cut less into your net yield), ability totrade all day, and avoiding loads and possible back-end redemption chargesthat a lot of funds have added in the last couple of years.

Q. What are those bank-loan funds you mentioned?

A. They buy slices of bank loans. These are lower-rated but heavilycollateralized loans from companies that can't issue commercial paper. Therates float, so your risk is quality (economic cycle!) rather than ratesrising.

Q. And finally, you mentioned closed-end bond funds.

A. Right. These usually trade on the stock market all day long like an ETF.There are all kinds of funds, from international to government to mortgageto corporates to junk bonds and municipal bonds. But a key thing to note isthat a large percentage of these funds use leverage, which will exaggerateany move in bond prices! And with a flatter curve there is a chance theywill need to cut their dividends as the leverage provides less advantage.

Q. How can you tell if a CEF is leveraged?

A. Call the 800 number and ask, or check it out on ETFconnect.com orCEFA.com. Often a quick giveaway is this: if the yield is above currentmarket rates, it means they are probably using leverage, or overpaying whatthey are actually earning.

Q. You did not recommend junk-bond funds, Don.

A. Right. I think it's too late in the economic cycle to take those risks.And that is an asset class with 5% average annual failures, and funds tendto be marketed on highest yield--usually meaning highest risk. So, I just donot think now is the time for them.

Q. Lots of choices!

A. Definitely. So, people need to think about their outlook (not theirincome need!) and choose accordingly.

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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).