Don’t Expect Another Year of Big Bond Gains

The investment forecasts are out for 1994, and many have a familiar ring: Bonds and bond mutual funds are likely to just “earn their coupons” over the year.

What this literally means is that investors will continue to collect the promised interest, or coupon, payments on their bonds. Except for the small fraction of bonds that go into default, investors routinely collect these payments, so it is no big deal to earn the coupon.

What the phrase really means is that investors can’t expect to reap more capital gains from dropping interest rates.

Over the past dozen years, bond prices have appreciated as interest rates have fallen, padding the return for investors. But with rates now at much lower levels, bond fund investors can’t presume that the capital gains tail wind will keep blowing.

Indeed, many bond fund managers concede that the riskiness of the bond market is rising, especially in view of the strengthening economy, which could add to inflationary pressures and thus put upward pressure on interest rates. As rates rise, the market value of existing fixed-rate bonds falls--producing capital losses for bond owners rather than capital gains.

This doesn’t necessarily mean you should abandon your bond fund holdings. These investments can add price stability to a stock portfolio. And unless interest rates rise sharply, the total return on intermediate- and long-term bonds--their yield plus or minus any appreciation or depreciation in principal value--probably will still beat the 2% to 3.5% yields available on Treasury bills, money market funds, certificates of deposit and the like.

But it does mean that an era of lower results on bond portfolios is around the corner.

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Over the past decade, bond funds have averaged nearly 11% a year, including both interest income and capital gains and after expenses were taken out.

To put that into perspective, 11% is slightly better than the stock market’s long-term performance and about twice as good as what bond investments have generated over most of this century.

There’s a danger that novice bond fund holders have grown complacent about the return potential on these products without understanding all the risks.

“We’ve done a lot of consumer testing, and we’ve found that people don’t understand the difference between total return and yield, and many think bond funds are insured by the FDIC,” says Debra McGinty-Poteet, senior vice president and managing director of Bank of America’s mutual fund division in Los Angeles.

Bond funds, she notes, have been the preferred choice of bank customers driven out of savings accounts by the yield crunch. Yet stock investments, not bonds, are where people should park their long-term money for capital appreciation, she says.

In the absence of further interest rate declines, the most promising area of the bond market heading into 1994 appears to be the municipal sector.

The demand for tax-free bonds has intensified in the wake of higher personal tax rates under President Clinton. Yet supplies also surged to record levels in 1992 and 1993, as cities, counties and state governments and their agencies rushed to refinance debt at attractive levels.

The result: Munis didn’t appreciate as much as other types of bonds--namely Treasuries, to which they are often compared.

“The fact is, municipals are even more attractive now relative to U.S. Treasury bonds than before the tax legislation was approved” in August, says Robert Dennis, manager of the Boston-based MFS Municipal Bond Fund.

Munis represent “a classic investment opportunity” in the view of Sandy Lincoln, chief investment officer of Kemper Mutual Funds in Chicago. While demand is expected to remain heavy in 1994, the supply of new bonds could dry up considerably.

For fixed-income investors willing to venture into more aggressive areas, two good choices could be funds that hold lower-rated junk domestic bonds and European debt securities.

Junk bond funds have had three straight years of double-digit returns. They’ve been sparked by a sharp drop in the supply of newly issued bonds and by an improving economy and lower borrowing costs--which have lessened default dangers. Even if investors only earn the coupon, they will be looking at returns of about 9% for 1994.

Funds with a large European bond exposure could do well if interest rates in those countries continue to drop. Les Nanberg, a senior vice president at MFS, believes European markets offer the best bond opportunities for 1994, as economic growth in Europe remains weak and interest rates stand at higher levels than in the United States.

The Office of the Comptroller of the Currency, which regulates national banks, has unveiled a brochure to alert savers that mutual funds don’t carry federal deposit insurance--even when sold by banks.

The free pamphlet, “Deposits & Investments: There’s a Critical Difference,” provides basic information on mutual funds and annuities, both of which are marketed at banks. It also offers tips for first-time investors.

The office has mailed brochures to all national banks. Investors can receive a copy by writing to the Consumer Information Center, P.O. Box 100, Pueblo, CO 81002.

Bargain hunters would be unlikely to find a more depressed category heading into 1994 than the environmental funds.

These portfolios invest in companies that either clean up pollution or minimize it at the source. The funds have lagged the market for four straight years. A recent issue of the Value Line Investment Survey ranked environmental stocks No. 93 in timeliness of 97 industry groups.

It might still be early to buy these funds, but 1993’s sharp rally in gold stocks showed that no sector remains prostrate forever.

Fidelity ((800) 544-8888), Invesco ((800) 525-8085), Kemper ((800) 621-1048) and Oppenheimer ((800) 525-7048) are among the fund families with larger environmental portfolios.

Bond Performance in Perspective

Bond mutual funds had another good year in 1993 and have returned almost 11% annually on average over the past decade. But with interest rates lower today, such good performance may be difficult to match in the future.

Historically, bond investments have returned closer to 5% a year. This chart shows average annual results for major asset classes from 1926 through 1992.

Investment Category Average Yearly Return Small stocks +12.2% Large stocks (Standard & Poor’s 500) +10.3% Long-term bonds (U.S. governments) +4.8% Cash (U.S. Treasury bills) +3.7% Inflation (Consumer Price Index) +3.1%

Source: Ibbotson Associates