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Fund Analyst Report: Intermediate-Government Funds

Today's low yields across government bond sectors argue for tempered expectations.

Miriam Sjoblom, 10/01/2010

The visible hand has kept a tight grip on intermediate-government funds.

At the outset of 2010, many forecasts called for another rough year for U.S. Treasuries. The opposite scenario has unfolded, though. Treasury yields have dropped, boosting long-maturity Treasury returns ahead of all other bond sectors so far this year. Investors' moods began to shift in the second quarter, when worries about the eurozone's sovereign debt crisis sparked renewed interest in the perceived safety of Treasuries. More recently, a string of disappointing economic data releases fueled further gains, pushing down yields on the 10-year note and 30-year bond to 2.5% and 3.5%, respectively, by the end of August (they've climbed somewhat since).

Treasuries' expectations-defying advance this year shows that predicting interest-rate moves is no easy task. Increased policy intervention adds another variable to the equation. The Federal Reserve's $1.25 trillion agency mortgage purchase program gave U.S. government-backed mortgage bonds a boost in 2009, for instance, even as Treasuries lost ground. (The program's end in March didn't bring about the mortgage sell-off some feared, though.) Then in August, the Fed announced plans to use principal paydowns from its mortgage bond portfolio to buy Treasuries. In his Aug. 27 speech in Jackson Hole, Wyo., Fed chairman Ben Bernanke expressed his intention to get creative, if necessary, to prevent deflation and further disinflation--a sign that short rates could remain low for some time yet.

Supportive monetary policy has contributed to strong returns for all types of intermediate government funds so far in 2010. The Fed has less control over where yields on intermediate- and long-maturity bonds go from here, though, and there's no denying that risk looms for funds in this category. Some managers are concerned that a prolonged period of low yields will accelerate mortgage refinancings. Because the average agency mortgage pass-through trades at a premium price of $106 today, any return of principal results in capital losses for Ginnie Mae and other mortgage-focused funds in the group. And after Treasuries' latest rally, their yields more closely resemble a coiled spring than they have since early 2009; funds in this group with heavy Treasury stakes look particularly vulnerable to rising yields. Real yields on Treasury Inflation-Protected Securities also look quite lean and court plenty of interest-rate risk themselves.

Even if nothing worse is in store, today's low yields across government bond sectors argue for tempered expectations. Recent months suggest government-bond funds continue to offer worthwhile diversification, though. Low fees and prudent management are absolutely essential in this group, and our wo Analyst Picks provide sterling examples of both.

Fidelity Government Income FGOVX
Morningstar Rating: 4 Stars
Year-to-Date Return: 6.79%
Expense Ratio: 0.45%

This fund offers broad exposure to a variety of government-bond types. It holds a mix of Treasury issues, mortgage securities, and government-agency bonds. That diversification provides stability for the fund, while allowing manager Bill Irving an opportunity to add value by shifting assets among the different sectors. The fund can be a bit more sensitive to interest-rate changes than the category norm, but we think that its broad diversification, low costs, and steady approach make it a strong choice.

Vanguard GNMA VFIIX
Morningstar Rating: 5 Stars
Year-to-Date Return: 6.30%
Expense Ratio: 0.23%

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