Q. I have a portion of my investments in Federated U.S. Government Securities II. It has had a negative return for the past quarter. One reason I invested in it was for fixed income and preservation of capital. As a retired senior on fixed income, I am adverse to losses. How can a fund based on government securities be losing in today's market?

---J.A., by email from Houston, TX

  

A. Mutual funds that invest in fixed income securities face three kinds of risk. One is manager risk---that the portfolio manager might make bad choices and not do as well as the average fund or an index fund. Another is credit risk--- that the bonds in the portfolio may decline in quality due to corporate problems. But the most important is interest rate risk--- that interest rates might rise, reducing the value of existing bonds at lower interest rates.

Federated's government funds have long-term records that suggest some manager risk. But the big factor is interest rate risk. As the Federal Reserve has raised short-term interest rates, it has had an impact on all fixed-income funds. One way to see this is to go to www.morningstar.com, click on "funds," and then click on "category returns." The page that comes up will show you fund returns, by category.

As of May 5, for instance, it showed that the average short-term government fund had returned 0.21 percent year to date, while the average intermediate-term government fund had returned a loss of 0.99 percent and the average long-term government fund had lost 5.50 percent. The average inflation protected government securities fund had lost 2.60 percent.

While the securities held in portfolios will mature at their stated value, their market value will fluctuate between the time they are issued and when they mature. Longer maturity bonds fluctuate in value more than short maturity bonds when interest rates change.

Fixed-income funds are appropriate investments for retiree portfolios because they fluctuate in value less than stock funds. They may also provide positive returns when stock funds are losing money. During the recent crash, for instance, bond funds rose in value because interest rates declined dramatically.

The best way to reduce risk significantly is to own a "ladder" of individual government securities or insured CDs. While the market value of the portfolio can still fluctuate, having bonds that mature in 1,2,3,4, and 5 years may enable you to avoid selling bonds before maturity if you need cash to meet an emergency.

  

Q. In July 2002 I purchased a significant number of shares in Vanguard GNMA at $10.58 a share. The NAV (net asset value) rose to $10.76 over the next few months and then began a steady decline to a recent low of $10.08 a share in early April. Initially, this was expected because mortgage rates were declining to historic lows and mortgages were being refinanced to lower rates.

But interest rates have been rising for two years and mortgage rates have started to rise. So I am surprised that the NAV has continued to fall. The result has been an annualized return under 3 percent over the last 3 years.

Lately, the NAV has increased slightly. Could this be the beginning of a rebound? I don't understand what is going on, and advisers are still highly recommending Vanguard GNMA. Is it time to get out or buy more?

---L.C., by email from Cedar Hill, TX

  

A. Advisers like Vanguard GNMA for a number of reasons. Its performance has been extraordinary over a long period of time. Ranked against intermediate government bond funds, for instance, it has been in the top 3 percent, 8 percent, 5 percent, and 10 percent over the 1, 3, 5, and 10 year periods ending May 8, 2006. Because it is a GNMA fund, it also tends to provide higher interest income than conventional government bond funds, so it's a good portfolio addition for those seeking current income.

Those superior percentile performances also tell you that your returns would have been significantly worse in conventional government bonds of similar maturity.

Being way better than most and a good producer of current income, however, doesn't mean it is immune from changes in interest rates. Indeed, all GNMA funds have the liability of not capturing rising bond values when interest rates decline and of being trapped in old, low rate mortgages when interest rates rise. That's the reason GNMA securities tend to offer a yield advantage over conventional bonds.

My suggestion: Tough it out. You've probably seen the worst.