. . . While Market May Be In for Cloudy Days

To be a sharp investor in bond mutual funds, you have to think like an Orwellian.

Just remember that bad economic news is good, and good economic news is bad. That’s because interest rates and inflation--which move inversely to bond prices--generally rise as the economy is improving and vice versa.

In recent months, of course, the economic news has been lousy, which helps explain why bond funds last year posted their best gains since 1985. But now some fixed-income professionals wonder if a turning point isn’t near.

With yields already at fairly low levels, they caution against pumping a lot of money into bond funds, especially if you’re moving cash out of a federally insured bank account for perhaps the first time.

“It’s not appropriate for new investors to rush out and buy bonds at the moment,” says James Midanek of Solon Asset Management Corp. in New Rochelle, N.Y. He believes that rates will ebb later in the year but worries that novices might not understand the risks they’re assuming when entering the bond market.

Bob Rodriguez, manager of the FPA New Income Fund in Los Angeles, is even more cautious. “I find very little value in the bond market right now,” he says. At current yields, bond investors aren’t being compensated sufficiently for the risks they must bear, Rodriguez says. He figures that inflation and interest rates will inch higher later in the year as the economy starts to improve in the second or third quarter.

Even if you don’t believe that rates are poised to turn upward soon, you should be aware of special risks centered in certain corners of the bond market, like that occupied by mortgage-backed securities. The danger is that yields could drop significantly as homeowners rush to refinance at today’s lower rates. As people refinance and old loans are paid off, investors in mortgage-backed products must reinvest the money they get back at today’s lower rates. One advantage of mutual funds is that the portfolio manager does this automatically, but fund shareholders still face the prospect of earning less interest.

Refinancings are a threat on securities issued by several housing agencies, of which the Government National Mortgage Assn. (GNMA or Ginnie Mae) is the major player. “Investors in high-coupon GNMAs will receive back their principal and will face reinvestment at a rate that is now several percentage points lower than the rate they previously enjoyed,” says Bruce Grenke of Asset Allocation Advisors, a money management firm in Walnut Creek, Calif.

That, in short, could lead to lower yields on mortgage portfolios, which have enjoyed a resurgence of popularity of late. Last year, sales of Ginnie Mae funds rose 146% to $13.8 billion, according to the Investment Company Institute, a mutual fund trade group in Washington.

A big selling point is that Ginnie Mae securities are guaranteed against default by the federal government. In addition, they generally yield more than money market funds and Treasury bonds, to which they’re often compared. However, like all bond products, Ginnie Maes will lose value in market trading if interest rates rise, which means that the funds could suffer a principal loss if sold by the fund prior to maturity. And, as noted, a unique risk with mortgage securities is that their yields could drop as homeowners refinance--even if interest rates stay flat.

“Refinancings will continue to happen at a very heavy pace at least throughout the first half of the year because so many applications are in the pipeline,” says Midanek, a mortgage-securities specialist.

However, not all Ginnie Maes are exposed to refinancing risk to the same degree. Higher-yielding securities--those backed by mortgages with rates of 10% to 11% or so--are most at risk. “With fixed mortgages now around the 8.5% level, homeowners paying higher rates have a big incentive to refinance,” says Rodriguez, who continues to hold some Ginnie Maes in his fund--but only those with low perceived refinancing risk.

Daniel Wiener, editor of the Vanguard Adviser newsletter in New York, doesn’t suggest that you avoid mortgage-backed funds altogether. But he does recommend playing it safe by sticking with portfolios that mostly hold bonds with lower yields of 8% or so. You can check the portfolio holdings by scanning the fund’s most recent report or asking the management company or your broker, if you use one.

Midanek offers an easy rule of thumb: If you compare two Ginnie Mae funds, the one with the higher yield probably carries more refinancing risk. He cautions that refinancing dangers also apply to adjustable-rate mortgage funds, which are short-term cousins to the regular Ginnie Mae products. ARM funds have been around since 1987 but really didn’t catch on until 1990. They invest in pools of adjustable-rate mortgages, offering investors fairly low volatility for a bond fund but higher yields than on money market products.

“Some investors may think they’re buying a money market fund with an incredibly high yield without having to take extra risks,” Midanek says. “They might not realize they can lose principal in an ARM fund.”