Safe bets.

Government bond funds are safe havens for weary investors

While the stock market experienced a slump in the second half of 2000 and the first half of 2001, the bond market bounced along, posting solid gains in 2000 and early 2001. For safety as well as income, government bond funds may be the place to stash some cash, says Darnell Perkins, a financial planner in Columbus, Ohio. "With the Federal Reserve lowering short-term interest rates, cash equivalents such as money market funds are not the place to be. You'll probably do better in bond funds, which can offer higher yields" However, not all government bond funds are the same. Morningstar Inc., Chicago, lists three categories of government bond funds:

Short-term funds. With an average maturity of fewer than five years, these instruments tend to offer the most stability. In the past 10 years, these funds have had only one downer, a 1.82% loss in 1994. Normally, yields in this category are on the low side, but in 2001 yields on short-term government funds were actually higher (5.5%) than the yields on long-term government funds (5,3%). This anomalous situation may not last now that the Fed is cutting short-term rates.

Long-term funds. With an average maturity of more than 15 years, these are the most volatile government bond funds. They post the biggest gains (23.05% in 1995) but suffer the biggest losses (-6.58% in 1994, -5.99% in 1999) in the group. Taking those risks have paid off, though: Over the past 10 years, annual returns of long-term government funds have topped 8%, two percentage points higher than the annual returns of short-term government funds.

Intermediate-term funds. These represent over 50% of the more than 250 government' bond funds tracked by Morningstar. "These are considered core funds by many investors," says Scott Berry, an analyst at Morningstar. "They tend to fall in between long- and short-term funds in yields, volatility, and total returns." As of this writing, maturities were under 10 years and the yield was 5.6%.

Just because a fund falls into the "government bond" category, don't assume that you'll be investing in a bunch of Treasury bonds, notes, and bills. According to Morningstar, only 25% of the assets in the intermediate-term government fund category are invested in Treasuries. If you're not buying Treasuries in a government bond fund, what are you buying? Other assets include bonds issued by federal agencies such as the Tennessee Valley Authority.

Mortgage-backed securities fit into the "government" category because most of them are issued by federal agencies such as the Government National Mortgage Association ("Ginnie Mae"), the Federal National Mortgage Association ("Fannie Mae"), and the Federal Home Loan Mortgage Corp. ("Freddie Mae"). "They have a little more risk because they're not Treasury securities, but the credit quality is still excellent," says Christopher Parr, a certified financial planner in Columbia, Maryland. With these mortgage-backed securities you need to worry about prepayment risk, not default risk. What is prepayment risk? This is how mortgage-backed securities work: The above-named federal agencies buy mortgages from various lenders, package them into pools of multiple mortgages, and then sell interests in these pools to investors. Therefore, investors step into the shoes of mortgage lenders, collecting monthly interest from many home owners. "Mortgage interest rates tend to be higher than the interest paid by Treasury securities, so investors benefit from higher yields" says Berry.

The catch? Mortgages get prepaid, at erratic intervals, when owners move to another home or when mortgages are refinanced. Thus, investors have to deal with returns of principal as well as interest income. Berry suggests "investors choose a government bond fund that's diversified, with Treasuries as well as mortgage-backed securities, for a combination of downside protection as well as upside potential. In addition, I'd look for a fund with a low expense ratio, which probably will make a big difference in total returns over the long term."

Top 5 Long-Term Government Funds

                      1-Year Ann.   3-Year Ann.   5-Year Ann.
                        Total         Total         Total
Fund Name (Ticker)     Return(*)     Return(*)     Return(*)

American Cent Targt      21.8%         7.56%         8.61%
2010 Inv (BTTNX)

American Cent Targt      19.21         7.33          9.87
2015 Inv (BTFTX)

PIMCO Long-Term US       18.82         7.98           N/A
Govt A (PFGAX)

Dreyfus US Treas         18.07         6.43          7.19
Long-Term (DRGBX)

PIMCO Long-Term          17.95         7.17           N/A
US Govt B (PFGBX)

                                                 Minimum
                      12 Month    Toll-Free      Initial
Fund Name (Ticker)    Yield(*)      Number      Investment

American Cent Targt    5.14%     800-345-2021     $2,500
2010 Inv (BTTNX)

American Cent Targt    5.54      800-345-2021      2,500
2015 Inv (BTFTX)

PIMCO Long-Term US     5.29      888-877-4626      2,500
Govt A (PFGAX)

Dreyfus US Treas       5.1       800-373-9387      2,500
Long-Term (DRGBX)

PIMCO Long-Term        4.6       888-877-4626      2,500
US Govt B (PFGBX)

(*) As of 2/28/01

Source: Morningstar Inc.
Top 5 Short-Term Government Funds

                        1-Year Ann.   3-Year Ann.   5-Year Ann.
                          Total         Total         Total
Fund Name (Ticker)       Return(*)     Return(*)     Return(*)

Merrill Lynch US Govt     12.59%         6.10%         6.51%
Mtg D (MDFSX)

Scudder GNMA AARP         12.37          6.18          6.48
(AGNMX)

Fidelity Intermediate     12.14          6.40          6.48
Govt (FSTGX)

Managers Interm Dur       12.06          5.95          6.66
Gov (MGIDX)

Merrill Lynch US Govt     12.01          5.56          5.97
Mtg B (MBFSX)

                                                   Minimum
                        12 Month    Toll-Free      Initial
Fund Name (Ticker)      Yield(*)      Number      Investment

Merrill Lynch US Govt    5.57%     800-637-3863     $1,000
Mtg D (MDFSX)

Scudder GNMA AARP        6.31      800-322-2282      1,000
(AGNMX)

Fidelity Intermediate    6.32      800-544-8888      2,500
Govt (FSTGX)

Managers Interm Dur      5.39      800-835-3879      2,000
Gov (MGIDX)

Merrill Lynch US Govt    5.08      800-637-3863      1,000
Mtg B (MBFSX)

(*) As of 2/28/01

Source: Morningstar Inc.