The Trouble With Treasuries

Government bond fund managers navigate bear market

As is the case for realtors, the three most important rules for government bond portfolio managers are: structure, structure and structure.

That was especially true in 1999, when bonds suffered one of the worst bear markets since 1994-the year when the Federal Reserve raised interest rates 300 basis points, or 3%. As recently as 1998, a number of economic crises prompted investors to pour money into U.S. Treasuries, the bonds issued by the government to finance federal debt.

But this year the situation has been nearly the opposite. Bonds have been rattled by the continuing strength of the economy, which has prompted three interest-rate hikes by the Fed. In turn, investors have sold Treasuries and other bonds, sending yields past 6% on 30-year Treasuries. This bearish environment has hurt the performance of long-term government bond funds, which had a negative cumulative total return of 6.16% through November 30, according to Chicago mutual fund researcher Morningstar.

So those bond fund managers who anticipated rising rates and structured their portfolios accordingly achieved better returns than their peers, according to Sarah Bush, an analyst with Morningstar. Still, few funds had positive total returns.

One exception was the $120 million Dreyfus Basic GNMA (Nasdaq: DIGFX) fund, in first place with a year-to-date cumulative total return of 3.05%, outstripping the average government bond fund. It’s almost an unfair comparison, given the structure of the portfolio. It invests primarily in Government National Mortgage Association, or Ginnie Mae, bonds, also called mortgage-backed securities. But according to the way Morningstar classifies government bond funds, it does fit in the category.

“We were certainly in the camp that thought rates would be rising and that the flight to quality [to Treasuries] would subside,” said Michael Hoeh, senior portfolio manager of the Dreyfus GNMA fund. Sector selection within GNMAs therefore played a major role in the performance of Hoeh’s fund. The fund invests primarily in plain-vanilla GNMA bonds, and has to have, at minimum, 65% in Ginnie Maes. Last year, Hoeh increased the fund’s exposure in GNMA ARMs (adjustable-rate mortgages) to 15% from nearly zero. He invested in Ginnie Mae securities maturing in 15 years.

Some fund managers who invested in Treasuries were able to beat their peers by mimicking the market instead of trying to beat it. “We’re an index fund, so we don’t try to do anything too clever,” says David Lindsay, senior vice president and portfolio manager of the $170 million Galaxy II U.S. Treasury Index (Nasdaq: IUTIX) fund. Lindsay says the key to his fund’s success was buying Treasuries with the same average maturity, whereas managers who didn’t do as well bought longer maturities. He invested in Treasuries maturing in from one to under 30 years and with coupons ranging from 4% to 12%.The fund mimics the Lehman Brothers U.S Treasury Index and the Salomon Brothers U.S. Treasury Index.

The structure played an important role in the performance of Lindsay’s fund. He points out that since the Treasury market is made up mostly of bonds with intermediate maturities, about 51% of the

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