(MONEY Magazine) – Bond fund investing keeps getting curiouser and curiouser. Remember 1989's first quarter, when interest rates rose sharply and many fixed-income fundholders saw their yield income all but wiped out by losses in share value? & Then, just when you thought the funds faced further pounding, they got a bracing boost instead. As rates thawed last spring, the funds produced uncommonly high total returns. In the second quarter, for instance, long-term zero-coupon bond funds were up 19.9% as a group, tops among fund categories, and overall, fixed-income funds gained 5.7% on average -- their best three- month showing in 12 quarters. But what next, and what dangers or opportunities lie ahead for bond fund investors? While most monetary authorities expect a continued cooling in rates (see Money Scorecard on page 6), many are convinced that the big downward move in long-term yields (rates on bonds with maturities of 10 to 30 years) may be largely over for now. They had already slipped from 9.3% in March to about 8.1% in early August. By contrast, rates on some short-term instruments have fallen relatively less in recent months. Thus many observers believe that as the economy slows further, short-term rates will fall the most, perhaps by as much as a percentage point or so by early 1990. Given that forecast, bond fund buyers should focus on portfolios whose bondholdings have an average weighted maturity of one to 10 years. Indeed, if you own shares in a long-term bond fund, you may have already enjoyed the greater part of your capital gains during the current round of rate declines. And should inflation spring back, causing an uptick in rates, you could give back some of those profits. Worse, confesses Steve Colton, portfolio manager of the Benham Target Series of zero funds, ''You would get killed in long zeros.'' (His Benham 2015, up 52.9%, is this month's top U.S. government bond fund on page 54.) Because they pay no interest until maturity (thus depriving you of the opportunity to reinvest at higher rates), zeros are the most volatile of bonds. In the following paragraphs, MONEYanalyzes fixed-income funds, category by category, starting with the least chancy: -- U.S. Treasury funds. Right now, funds that invest in intermediate-term Treasuries are the best bet for conservative income investors. That's because Uncle Sam guarantees payment of principal and interest on the funds' holdings and, unlike many other types of bonds, Treasuries cannot be called (redeemed early) or refinanced (replaced with bonds paying lower rates). But only the fund's bonds and notes are guaranteed -- not its yield or total return (income plus price change). Thus rising rates would cause the value of Treasury fund holdings to decline, resulting in a partial loss of your principal. Since the impact of such changes is less severe for intermediate-term than for long-term funds, be sure to check a fund's average weighted maturity with the management company's phone representative. Take note of fund fees as well; you'll find them in the prospectus. Look for a fund whose expense ratio is 1% or less. Two intermediate-term funds that meet these criteria are Dreyfus U.S. Government Intermediate (no load; 800-645-6561) and Pru-Bache Government Intermediate (no load; 800-225-1852). -- Mortgage-backed securities. The popular Ginnie Mae funds -- which hold shares in pools of VA and FHA mortgages -- would seem an even better bet than Treasuries. Not only is the payment of interest and principal guaranteed by the government, but the funds' yields have recently been running 1 1/2 percentage points higher than those of comparable Treasuries as well. There's an important reason for the higher compensation, however. When interest rates fall, homeowners refinance their mortgages, which means funds receive big returns of capital and must reinvest it for shareholders at the then lower rates. ''If a fund promises an 11% to 12% return in the current interest-rate environment,'' notes Patricia Zlotin, senior vice president for fixed-income investing at Massachusetts Financial Services, ''it probably has a slug of premium Ginnie Maes that will be refinanced.'' Also check with the fund's phone representative to be sure distributions do not include a return of principal, which cuts into your savings. Two funds that avoid these traps are Benham Ginnie Mae (no load; 800-472-3389) and Massachusetts Financial Government Guaranteed Securities (4.75% load; 800-225-2606, 617-954-5000 in Massachusetts). -- Tax-exempt bonds. Municipal bonds issued by state and local governments are beloved by high-bracket taxpayers because their yields are not subject to federal tax or, usually, local levies (if you buy a fund that restricts itself to bonds issued in your state). But munis can be redeemed early -- and probably will be in large volumes if interest rates continue to drop. Since most munis can't be called until 10 years from the date of issue, however, one way to avoid the problem is to select a fund that currently consists largely of newly issued bonds, such as Vanguard Muni-Intermediate-Term (no load; 800-662-7447). -- Zero-coupon bonds. As with conventional Treasury bond funds, the most prudent buying opportunity in zero-coupon bond funds these days is in those with average maturities of 10 years or less. But note that about the only reasons to buy a zero fund rather than individual zeros are lower transaction costs, which appeal mainly to traders who want to catch interest-rate moves, and flexibility, which is desirable if you want to build your position by adding small sums periodically. In any case, investors certainly don't get into zero funds for their managers' bond-trading prowess, because zero-coupon bond funds, whose holdings are targeted to mature in a specified year, look and act a lot more like fixed unit investment trusts than they do mutual funds. Bonds are traded only to accommodate sales and redemptions, and when the securities mature, the fund is liquidated. Fund investors thus pay a steep price for not much. For example, even though the Benham Target Series-2000 zero fund is a no-load, the cumulative effect of its 0.7% annual management and administrative fees on an investment that is held to maturity and grows at the fund's historic annual rate will erode 7.5% from the total return on your shares, notes Richard Spellman, publisher of the Mutual Fund Fee Index. By contrast, direct purchase of a $5,000 zero maturing in 2000 probably would incur a $100 brokerage charge, a mere 2% of your investment. -- High-grade corporates. On the face of it, high-grade corporate bond funds -- those whose securities have a credit rating of BBB or better -- look great. Their total return for 1989 through June 30 averages 8.3%, and their average yield lately was 9.3%. But Ian MacKinnon, director of fixed-income research at the Vanguard Group, warns that these funds could suffer increasingly from the galactic debt that companies assume in takeovers and leveraged buy-outs. ''It can turn industrial bonds into industrial bombs that blow up in your face,'' says MacKinnon. One solution: buy a fund, such as Bond Fund of America (4.75% load; 800-421-9900, 714-671-7000 in California), that primarily holds bonds in industries where takeovers are rare, such as utilities. -- World income. Returns for world income funds -- which lost 1.6% in the first half as the stronger U.S. dollar cut into the value of the funds' foreign bondholdings -- could turn around modestly over the next year if falling U.S. interest rates put downward pressure on the greenback. Therefore, Jon Woronoff, publisher of International Fund Monitor, suggests that as U.S. | rates decline, investors seeking international diversification might start moving as much as 30% of their fixed-income portfolio into world income funds like Freedom Global Income Plus (3% back-end load; 800-225-6258, 800-392-6037 in Massachusetts). Because of the sensitivity of foreign bonds to currency rate changes, however, these funds are only for long-term players. -- High yield. Junk bond funds -- those with portfolios of securities rated BB or lower -- have so underperformed other bond funds that, in one respect at least, they are actually starting to look good, says A. Michael Lipper, president of the fund-tracking Lipper Analytical Services. Specifically, the spread between junk and Treasury bond yields has recently widened invitingly from three to five percentage points, more adequately compensating for potential default in recession-sensitive high-yield bonds. Still, says Kurt Brouwer, a San Francisco-based investment adviser: ''If you can't take a wild ride, don't buy a junk fund'' -- especially not with recession fears on the rise.

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