Bond Funds Post Quarterly Gains After Earlier Losses

Bond mutual funds--the other mutual funds, as it were--mostly managed to post positive total returns in the second quarter, after widespread first-quarter losses.

But longer-term U.S. bond funds still suffered declining principal values last quarter, as market interest rates ended higher than they were at April 1, thus devaluing existing bonds.

And most bond funds’ returns for the quarter and the first half were well below stock funds’ returns, continuing a trend that has been in place since early 1994, and which has fueled record purchases of stock funds partly at bonds’ expense.

Fund tracker Lipper Analytical Services reported Wednesday that the average taxable bond fund had a positive total return of 0.64% in the second quarter, after a 0.90% first-quarter loss.

Total return is fund interest earnings plus or minus any change in principal value. In both the first and second quarters rising market interest rates produced principal losses for many bond fund owners, but in the second quarter the losses weren’t deep enough to totally offset fund interest earnings.

Among major bond fund categories:

* The big winners were risky funds that own bonds of “emerging markets,” such as Mexico. They scored a 10.77% average total return in the quarter as big U.S. investors snapped up many of those high-yielding issues, driving prices up.

* U.S. corporate junk bond funds gained 2.03% on average in the quarter, as their high yields rewarded investors despite some principal erosion. Wall Street’s boom helped junk bonds: Some of the issuers of those high-risk bonds were able to raise fresh equity capital, improving their financial health.

* California municipal bond funds were up 0.79% on average, as munis’ attractive tax-free yields relative to taxable yields (such as on U.S. Treasury issues) drew more buyers. The apparent demise of the “flat tax” idea also encouraged muni investors.

* At the bottom of the list, long-term U.S. government bond funds eked out a 0.05% total return for the quarter, on average, though they remain off 2.6% for the year to date.

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In contrast, investors who just stayed put in short-term money market funds earned 1.14% for the quarter and 2.3% for the half, Lipper said.

Long-term bonds are almost always hurt more than shorter-term bonds when market interest rates rise. In the first half of ’96 the U.S. economy’s resilience sent rates surging as investors began to bet that the Federal Reserve will have to tighten credit again soon to keep inflation from picking up.

But the Fed ended a policy meeting Wednesday without changing rates. And some analysts, despite being taken by surprise by the economy’s strength and by the jump in market rates this year, still think an economic slowdown is imminent--which could allow rates to fall, boosting bond values.

Scott Grannis, economist at Western Asset Management in Pasadena, says “core” inflation measures that exclude short-term swings in food and energy prices indicate inflation is running at about a 2% annualized rate, which he says doesn’t justify higher interest rates. He also notes that gold and other metal prices have been falling lately--a deflationary, not inflationary, signal.

“I don’t see the need [for the Fed] to tighten at all in this kind of environment,” he said.

But he’s in the minority: Many investors think rates will go up between now and 1997. Which means that for the true “contrarian” who likes to bet against the crowd, there’s hardly a more obvious bet than bonds today--especially if you think the economy’s spring pace is unsustainable.

For many small investors, however, bonds are an afterthought, if they’re a thought at all. U.S. bond fund yields are mostly in the 6% to 6.5% range, hardly eye-popping. Stock funds, which rose 10.8% on average in the first half after rocketing 31.1% in 1995, are luring all the dollars these days. Stock fund assets now total $1.53 trillion to bond funds’ $821 billion.

A bond optimist might say that those numbers just mean there’s a lot of capital that could come flying out of stocks and into the relative safety of bonds, when stock investors one day learn that that market isn’t a one-way ticket.

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How Bond Funds Fared

Here are average total returns for key categories of bond mutual funds for the second quarter and first half, and current average annualized yields for the funds. Total return includes interest earnings plus or minus any change in the bonds’ principal value.

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Avg. total return Fund category 2nd Qtr. 1st half Avg. yield Emerging market bonds +10.77% +15.2% 8.99% Global bonds, long-term +2.09% +1.7% 7.57% Junk corporate bonds +2.03% +4.8% 9.11% Mixed bonds +1.26% +0.7% 6.89% Adjustable rate mortgage bonds +1.20% +2.1% 5.68% Money market +1.14% +2.3% 4.91% Calif. muni bonds, long-term +0.79% -1.4% 5.15% High-quality corporate bonds, 1- to 5-year +0.68% +0.3% 5.93% General muni bonds, long-term +0.52% -1.4% 5.05% U.S. govt. bonds, 1- to 5-year +0.49% -0.2% 5.95% High-quality corporate bonds, 5- to 10-year +0.37% -1.4% 6.07% GNMA bonds +0.30% -0.9% 6.47% Lower-quality corporate bonds, long-term +0.26% -2.3% 6.50% High-quality corporate bonds, long-term +0.22% -2.3% 6.12% U.S. govt. bonds 5- to 10-year +0.22% -1.5% 5.99% U.S. govt. bonds, long-term +0.05% -2.6% 6.12%

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Source: Lipper Analytical Services Inc.