Bond Fund Party Runs Out of Juice : Investment: Owners enjoyed hefty first-quarter profits. But with rates rising, what now?

Bank savers who became bond mutual fund investors early this year--in search of yield--were rewarded with hefty first-quarter returns on most types of funds, figures released Monday show.

But the decline in market interest rates that fueled the winter bond rally has run out of gas. Now, rates have turned higher again--chipping away at bond owners’ principal values.

The rise in rates, which began in March, still wasn’t enough to significantly hurt first-quarter bond fund returns. Most bond funds posted gains of 3.8% or better, topping the 3.3% total return on the average stock fund, according to results released Monday by fund tracker Lipper Analytical Services in New York.

The best-performing bond funds in the first quarter: high-yield junk corporate issues. Funds that own those bonds gained 6.72% in the quarter, adding to their 17.7% total return for all of 1992.

Meanwhile, the average long-term U.S. government bond fund gained 3.83% in the quarter, and the average long-term California municipal bond fund rose 4.12%.

Bond fund returns measure both the interest earned and the net change in principal value. If market interest rates are falling, older, higher-yielding bonds become more valuable--so the principal value (share price) rises.

But when market interest rates inch up, the value of existing bonds is eroded as investors shun them in favor of new bonds at better yields.

In the first quarter, appreciation of principal accounted for most of the average bond fund’s return. Example:

* The typical long-term U.S. government fund pays an annualized yield of 6.8%, according to Lipper. That means you earn about 1.7 points in interest quarterly.

* Subtracting 1.7 points from the government funds’ average first-quarter return of 3.83% gives you a net gain in principal of 2.13 points--courtesy of the big drop in market interest rates in February.

Since early March, however, rates have been rising again as worries about higher inflation have gripped the bond market. The result, says Lipper, is that 20 of 27 bond fund categories lost principal value in March.

Where do bond funds go from here? Most bond experts still believe that the uptick in interest rates is just that--an uptick. “I think we’re in a correction here rather than a new direction for interest rates,” says Jack Utter, manager of the IDS Strategy Income bond fund in Minneapolis.

Inflation worries should abate as additional economic reports support the idea that economic growth remains moderate at best, Utter says. So he figures that interest rates will stabilize before long.

But he and many other bond fund managers caution that they do not believe there is room for another dramatic drop in interest rates from current levels. Much of the rate slide in January and February was sparked by optimism about President Clinton’s federal budget deficit reduction plan.

But “the deficit-reduction factor has played out fully in the market,” argues Anthony Karydakis, strategist at First Chicago Capital Markets. For the next six months or so, “I think we’re going to be in a fairly narrow trading range on interest rates.”

That means, at best, you’ll earn your interest return on your bond fund--but forget any increase in principal value.

Even so, earning 5% to 7% in interest from a bond fund still beats the alternative of 2.7% from a money market fund, says Randy Merk, manager of the Benham Government Agency fund.

“We’re not expecting a large rally in bonds, but the cost of being in cash is just deadly,” Merk says.

If you’re looking to invest in bonds now, many experts say two fund sectors look attractive:

* Corporate bond funds, including junk funds, because they pay more than U.S. Treasury issues and are helped by an improving economy (as corporate credit ratings rise). Utter’s fund is 60% invested in corporate issues now.

* Tax-exempt muni funds, because yields have been pushed up as purchases of munis have slowed, which is typical at this time of year. Yields on top-quality 10-year muni bonds now are 84% of taxable yields on Treasury issues, says Mike Niedermeyer, senior vice president at Wells Fargo Asset Management in San Francisco.

Given the tax-free status of muni yields, that’s a rich return, he argues--especially considering the oncoming Clinton tax hikes.

How Bond Funds Fared Here are average total returns for key categories of bond mutual funds for three periods ended March 31. Total return includes interest earnings plus or minus any change in the bonds’ principal value.

Average total return Fund category 1st Qtr. 12 mos. 5 yrs. Junk corporate bonds +6.72% +15.7% +63.2% Lower-quality corporate bonds, long-term +5.07% +14.7% +64.9% Global bonds, long-term +5.07% +10.3% +52.1% Mixed bonds +5.01% +14.0% +60.5% High-quality corporate bonds, long-term +4.81% +14.0% +65.6% High-quality corporate bonds, 5- to 10-year +4.23% +12.7% +60.4% Calif. muni bonds, long-term +4.12% +12.6% +57.7% U.S. govt. bonds 5- to 10-year +3.85% +12.0% +56.9% U.S. govt. bonds, long-term +3.83% +12.6% +58.9% General muni bonds, long-term +3.80% +12.7% +58.6% GNMA bonds +3.04% +11.1% +61.5% U.S. govt. bonds, 1- to 5-year +2.54% +9.1% +50.0% High-quality corporate bonds, 1- to 5-year +2.48% +8.5% +49.5% Global money market +1.70% +0.3% +44.6% Adjustable rate mortgage bonds +1.35% +5.2% +45.2% Money market +0.65% +3.0% +35.8%

Source: Lipper Analytical Services Inc.