Bond Mutual Funds Add to Their Gains : Investors: Falling yields boost fund share prices, though stocks have stolen limelight--so far.

Bond mutual funds continued to play the tortoise to stock funds’ hare in the third quarter.

The average taxable bond fund posted a total return of 1.83% in the quarter ended Sept. 30, compared to the average general stock fund’s gain of 8.9%, according to Lipper Analytical Services.

For the first nine months of the year, the average bond fund’s gain was 11.2%, contrasted with 27.3% for the average stock fund.

Of course, in bullish markets stocks almost always outrun bonds. And after the bond market’s sorry performance last year--when interest rates surged, causing bond values to plunge--many bond fund investors may be happy just to be back in black ink this year.

Bonds now have rallied for three straight quarters as market interest rates have fallen with the weak economy. More than half of the 11.2% total return on the average taxable bond fund this year has come from price appreciation, thanks to lower rates. The rest of the return is interest income--the primary reason that investors buy bond funds.

In recent days, long-term interest rates have renewed their decline, as more investors have become convinced that the economy isn’t going to rev up any time soon. The bellwether 30-year Treasury bond yield hit a new 20-month low of 6.43% on Wednesday.

Some market pros think rates could slip further if the economy and inflation remain subdued--and if Congress and the White House finally agree on a long-term plan to balance the federal budget.

“If everything breaks exactly right for bonds, we could see yields at perhaps 6.2%” on the 30-year T-bond before year-end, says David Jones, economist at Aubrey G. Lanston & Co. in New York.

And with the stock market in a slump, bonds’ ongoing rally could attract money out of stocks and into bonds, giving the latter a performance edge in the fourth quarter, some experts say.

But Jones cautions that in 1996, the economy may turn up and that would probably lift bond yields somewhat as well, at least temporarily. Even so, he doesn’t expect a repeat of 1994, when short-term rates doubled and long-term rates moved up nearly 2.5 percentage points.

When all is said and done, bonds in 1996 could be stuck in a “sideways-moving” market, Jones says, with long-term Treasury bond yields perhaps trading in a range of 6% to 7%. That would allow bond fund investors to earn their interest return with either a fairly minor capital gain or loss, depending on rates’ ultimate direction.

For investors who want to stay in bonds but who worry about interest-rate blips, experts suggest looking at intermediate-term bond funds, which typically own bonds in the five- to 10-year maturity range.

Intermediate-term bonds tend to yield close to what longer-term bonds pay, but they usually don’t suffer the same volatile price swings.

For example, in the first nine months of this year, the average total return on intermediate U.S. government bond funds was 11.4%, according to Lipper.

That amounted to 92% of the return earned by long-term government bond funds (12.4%), with much less risk, analysts note.

Some bond pros also say investors who expect the economy to remain healthy enough to avoid an upturn in corporate credit problems should consider “junk” corporate bond funds, which own high-yielding securities.

Those funds came on strong in the third quarter, with an average total return of 3.14%. The average year-to-date gain is 13.2%.

Tax-free municipal bonds also rallied sharply in the quarter. Funds that own long-term insured California muni bonds gained 2.53% on average and are up 12.7% this year, Lipper says.

Because some investors have been avoiding muni bonds--fearing that possible federal tax reform could wipe out munis’ tax-advantaged status--yields remain alluring for high-tax-bracket investors, some pros say.

For investors who can accept the tax-reform risk, “I think long-term munis are screaming buys,” said David MacEwen, muni fund manager at Benham Management. Long-term muni fund yields are generally in the 5% to 5.5% range, which is equivalent to taxable yields of around 8% or better for high-bracket investors.

Overall, bond mutual funds are once again providing much better returns than super-safe money market funds. Money funds’ average return year-to-date is just 4%, according to Lipper.

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How Bond Funds Fared

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

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Average total return Fund category 3rd Qtr. 9 mos. 5 yrs. Junk corporate bonds +3.14% +13.2% +102.4% Mixed bonds +2.59 +13.3 +72.1 Calif muni bonds, long-term insured +2.53 +12.7 +50.6 Calif muni bonds, long-term +2.40 +12.3 +48.0 General muni bonds, long-term +2.35 +11.6 +49.6 Global money market +2.32 +5.5 +22.1 Lower-quality corporate bonds, long-term +2.10 +14.5 +67.1 GNMA bonds +1.89 +12.3 +49.4 Global bonds, long-term +1.87 +12.7 +48.6 High-quality corporate bonds, long-term +1.85 +13.6 +59.4 U.S. govt. bonds, long-term +1.74 +12.4 +50.9 High-quality corporate bonds, 5- to 10-year +1.73 +12.1 +53.3 U.S. govt. bonds 5- to 10-year +1.58 +11.4 +47.8 High-quality corporate bonds, 1- to 5-year +1.52 +8.1 +41.6 U.S. govt. bonds, 1- to 5-year +1.43 +8.4 +38.7 Money market +1.30 +4.0 +23.1 Adjustable rate mortgage bonds +0.57 +3.4 +31.3

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Source: Lipper Analytical Services Inc.