U.S. bond mutual funds may post their biggest quarterly declines since 1990 as concern about possible interest rate increases by the Federal Reserve reduce the value of fixed-income securities.

Bond funds fell 2.63 percent on average from the end of March through May 10, according to data from Lipper Inc. Unless markets improve by the end of June, the funds will have recorded their largest losses since the first quarter of 1990 when they slipped 4.02 percent, New York-based Lipper reported.

The U.S. Treasury’s benchmark 10-year note has declined 7.3 percent after interest payments since March 15, as the yield has risen more than 1 percentage point on evidence of faster job growth and inflation. Expectations that the Fed will raise rates increased last week after Chairman Alan Greenspan and other governors dropped their pledge to be patient.

``It’s extraordinary to me how much rates have backed up,’’ said George Fischer, 42, who runs the $4.1 billion Fidelity Government Income Fund, in an interview from his Merrimack, New Hampshire office. The sell-off is anticipating rate increases of several percentage points by the Fed, he said.

The 10-year note’s yield on May 12 reached 4.80 percent, the highest since July 2002, and up from 3.65 percent on March 17. The yield exceeded the Fed’s target overnight bank-lending rate, currently 1 percent, by the most since 1992.

Investor Complacency

Before the recent market decline, investors were complacent much like they were before the Fed increased rates in 1994, according to Art Steinmetz, 45, manager of the $6.6 billion Oppenheimer Strategic Income Fund.

``There was a lot of concern about weakness in the economy and people seemed to think the Fed would be on hold forever,’’ Steinmetz said in an interview from his office in New York. Then signs of economic strength emerged, including the March jobs reports, and Greenspan began ``an extraordinary job of telegraphing,’’ he said.

Oppenheimer had kept the interest-rate sensitivity of its funds at the lowest level permitted by their prospectuses over the past six months, Steinmetz said. He said he moved the funds ``closer to neutral,’’ anticipating a 0.25 percentage point increase in the overnight bank lending rate this year.

The value of the Oppenheimer Strategic Income Fund has declined 3.5 percent since March 15.

Fed and 1994

Ten years ago, many investors were caught off guard as the Fed increased rates 3 percentage points in 12 months and the yield on the U.S. Treasury’s 10-year note rose from 5.56 percent to more than 8 percent. Funds posted losses of more than 1 percent in the first, second and fourth quarters of 1994, according to Lipper.

Robert MacIntosh, chief economist at Eaton Vance in Boston, who has been following the fixed-income markets since 1986, calls the recent decline ``right up there with the worst.’’ It’s not as bad as 1994, which he calls ``the worst ever,’’ or 1999.

``Every one is different,’’ said the 70-year-old Dan Fuss, co-manager of the $2.5 billion Loomis Sayles Bond Fund in Boston. This time around, the Fed has been using an ``open-mouth policy’’ to help investors anticipate rate decisions, he said.

Before the market drop, Fuss had about half of the funds’ assets that he oversees in securities with maturities of five years or less, well above the 20 percent allocation typical for short-term securities.

Now, Fuss said he’s looking for corporate and high-yield bonds trading for less than par, or below their issuing price. The strengthening economy that is prompting interest rates to climb and the Fed to tighten should ultimately bolster companies in economically sensitive industries, he said, declining to be more specific about what bonds he may buy.

Rydex Juno Fund

Jim Claire, 40, head of fixed-income trading at Evergreen Funds in Charlotte, North Carolina, said the market has overreacted to the economic news. Still, Evergreen’s funds are positioned defensively at about 85 percent of the interest-rate sensitivity, or duration, of their benchmark indexes, he said.

``Greenspan knows that Wall Street is looking at every sentence in every one of his statements,’’ he said. ``The market is keying off that so much.’’

Not every bond fund posted losses in the past two months. The Rydex Juno Fund uses borrowed bonds and futures to gain when the Treasury’s 30-year bond falls in price. The fund gained 10 percent in price from the end of March through May 10.

``We see people looking for an opportunity to gain from rising rates as well as downside protection for their portfolios,’’ said Anne Ruff, who oversees the fund. Since Rockville, Maryland-based Rydex created the fund in 1995, it has had only three years when it rose in value.

Below is a table of the 10 biggest U.S. funds investing in U.S. government bonds.

Assets Return

(Since March 31) PIMCO Total Return $74.3 Billion -3.57% Bond Fund of America $17.6 Billion -3.78% PIMCO Low Duration $14.6 Billion -1.27% PIMCO Real Return $10.8 Billion -5.43% Lord Abbett Bond Debenture $8.5 Billion -3.04% Fidelity Intermediate Bond $6.8 Billion -3.60% Oppenheimer Strategic Income $6.6 Billion -4.05% Dodge & Cox Income $6.4 Billion -3.15% Vanguard Inflation-Protected $6.1 Billion -5.48% Putnam Diversified Income $5.9 Billion -3.58%

Source: Data compiled by Bloomberg. Total assets based on most recently reported figures. Returns based on primary or A-share class. Performance reported for March 31 through May 10.

(Bloomberg)