Bond Investors May Find Days of Easy Money Over

Bond mutual funds scored hefty returns in the third quarter, rewarding the many new investors who have poured into the funds this year in search of higher yields.

Looking into 1993, however, many experts suggest that bond investors lower their expectations--and perhaps reshuffle their portfolios for some new realities. The easy money is most likely over.

The average bond fund jumped 3.85% in the quarter ended Sept. 30, an annualized return in excess of 16%, says fund-tracker Lipper Analytical Services in New York.

For the year to date, the average bond fund is up 7.64%, far surpassing the average stock fund’s return of a mere 0.04%.

Bond fund returns measure both the funds’ interest yield--the primary reason most investors buy bonds--and price appreciation, which occurs when market interest rates drop, boosting the value of older, higher-yielding bonds.

Because market rates have been dropping for two years as the Federal Reserve has eased credit, bond fund investors have reaped far higher total returns than the 5% to 9% annual interest yields paid by the funds.

In fact, bonds have performed so well for so long that the average bond fund return now greatly exceeds the average stock fund return, measured back to 1987. Lipper’s numbers show bond funds up 64.49% over the last five years, versus a 45.17% gain for stock funds.

That’s a problem, says fund guru Michael Lipper, head of Lipper Analytical: Over the very long term, stocks have always outpaced bonds because stocks represent a stake in the economy’s growth. Given bonds’ strong gains since 1987, history suggests that they’re ready for a much less exciting period ahead in which stocks should reclaim the performance lead.

Indeed, many experts believe that the long period of falling interest rates is almost certainly coming to a close, give or take one final Fed cut.

“I think the party is about over,” says William Griggs at investment firm Griggs & Santow in New York. “Whoever is elected President is going to give the economy some kind of boost, and will try to do so fairly quickly.”

A healthier economy would mean greater demand for money and thus firm or rising interest rates in 1993. So at best, bond owners would earn their interest return, but none of the capital appreciation they have come to expect. At worst, a rise in market rates would slice into older bonds’ values, offsetting some of the interest earnings and thus reducing bond funds’ total returns.

What should fund investors do now? Bond funds’ third-quarter results provide some clues:

* Stick with short-term or intermediate-term corporate bond funds. Short-term corporate funds, which rose an average 2.89% in the quarter, invest in bonds maturing within five years. Intermediate-term corporate funds, up 4.52% in the quarter, typically own bonds maturing in five to 10 years. Both categories have shown good results all year.

Annualized yields on shorter-term corporate funds now are mostly in the 5% to 6.5% range, while intermediate-term funds yield 6.5% and higher. But the key is to look beyond the yields: Bonds of short- and intermediate-term maturities will drop less in value should market rates rise next year, at least when compared to the damage that would occur to very long-term bonds.

Another plus for corporate bonds: They can become more attractive if the economy rebounds because a recovery would boost confidence in companies’ financial health. On that front, the picture continues to improve. The Miami Lakes, Fla.-based Bond Investors Assn. said Tuesday that corporate bond defaults totaled just $1.4 billion in the quarter, the lowest quarterly total since 1988.

Do-it-yourself investors can find these funds at any of the major no-load fund companies, including Vanguard, Fidelity and T. Rowe Price.

* In an uncertain environment, diversify. In recent years, many investors have instinctively bought funds that own U.S. Treasury bonds because of the implied safety of those bonds. But if interest rates indeed turn up next year, Treasury bonds could be hurt the most: Because they are so liquid, they are often the first bonds that investors dump when they sense higher interest rates on the horizon.

A smarter fund choice today might be mixed bond funds, which can diversify among government, corporate and foreign bonds depending on which groups look most attractive at any given moment.

In the third quarter, mixed funds gained 4.19% on average, and for the year to date they’re up 8.7%--better than all other fund categories except corporate junk bonds.

Carl Ericson, who manages the Colonial Strategic Income mixed-bond fund in Boston, figures the ability to be flexible will be more important than ever in an uncertain bond market next year. He now holds 45% of his fund in high-yielding corporate bonds, 25% in foreign bonds and the rest in shorter-term U.S. government issues. The fund’s current yield: about 7.5%.

In Los Angeles, the First Pacific Advisors New Income fund, managed by Robert Rodriguez, holds about 63% of its assets in U.S. government agency issues (including mortgage bonds), and 22% in convertible and non-convertible corporate bonds. His fund yields about 6.7%.

Rodriguez figures most of the decline in interest rates is over, so he’s fishing for good yields among overlooked bonds, while still attempting to protect principal value by keeping his average bond maturity in the five-year range, he says. Even so, he warns, next year will be tougher for bond investors. He estimates that his fund’s total return will be in the 4.5% to 7% range next year, down from more than 9% so far this year.

How Bond Funds Fared

Here are average total returns for key categories of bond mutual funds for three periods ended Sept. 30. Total return includes interest earnings plus or minus any change in the bonds’ principal value.

Average total return Fund category 3rd Qtr. 9 mos. 5 yrs. High-quality corporate bonds, long-term +4.82% +7.4% +73.0% Lower-quality corporate bonds, long-term +4.77% +8.0% +70.7% High-quality corporate bonds, 5- to 10-year +4.52% +7.2% +65.9% U.S. govt. bonds 5- to 10-year +4.33% +6.7% +64.5% Mixed bonds +4.19% +8.7% +64.7% U.S. govt. bonds, long-term +4.07% +6.0% +65.7% Junk corporate bonds +4.03% +16.0% +53.0% GNMA bonds +3.32% +6.0% +71.3% High-quality corporate bonds, 1- to 5-year +2.89% +5.9% +54.0% U.S. govt. bonds, 1- to 5-year +2.89% +5.4% +55.3% General muni bonds, long-term +2.28% +6.7% +62.5% Calif. muni bonds, long-term +2.12% +6.3% +60.9% Global bonds, long-term +1.92% +3.9% +71.7% Adjustable rate mortgage bonds +1.22% +4.1% NA Money market +0.74% +2.6% +38.4% Global money market -3.08% -0.1% +63.1%

Source: Lipper Analytical Services Inc.

End of the Party?

Bond mutual funds have posted higher returns than stock funds this year and for the last five years. But historically stocks always return more, experts say--which suggests bond funds’ strong run may be ending.

Five year average total return, period ending Sept. 30:

Stock funds: +45.17%

Bond funds: +64.49%

Returns are for average general stock funds and general fixed-income funds.

Source: Lipper Analytic Services Inc.