Will Safe Stop Being Sorry?
Investing in bonds in the first half of 1997 was quite a lot like investing in stocks: If you just stayed with what was popular--no matter how much the risk appeared to increase--you did quite well.
But going forward, some bond market pros think that the surprise of the second half of 1997 may be that the bonds that have been largely unpopular--namely U.S. Treasury issues--could suddenly be in hot demand.
In the first half of the year, however, bond mutual fund investors reaped the biggest rewards if they were in the highest-risk fund categories, including emerging-market bond funds, corporate high-yield (“junk”) funds and so-called multi-sector funds that typically own an assortment of bonds.
The returns on those funds, in fact, in some cases rivaled what stock mutual fund owners earned, according to the midyear bond fund tally from Lipper Analytical Services in New York.
The average emerging-market bond fund, for example, scored a total return (interest earnings plus principal appreciation) of 9.9% in the second quarter, bringing the first-half return to 12.1%--not much below the 13% total return of the average U.S. stock fund.
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In contrast, investors who played it safe in the first half, holding tight to U.S. government bond funds, earned returns that were little better than what money market mutual funds paid.
The average long-term government bond fund, for instance, recorded a total return of 3.5% in the second quarter, which after the first quarter’s losses meant a 2.5% total return for the first half.
In the same period, cash left in a money market fund earned about 2.4%, Lipper said.
The ongoing story in the bond market is the global hunger for yield: As interest rates have trended lower worldwide since 1995, investors have increasingly tripped over each other rushing into higher-yielding--and thus, higher-risk--types of bonds.
That trend accelerated over the last year. Hence, emerging-market bond funds, which typically own bonds of such developing countries as Mexico, Russia and the Czech Republic, produced a stunning 38.7% total return, on average, in the year ended June 30.
That was far better than the 18% return earned by the average emerging-market stock fund.
Similarly, corporate junk bond funds’ average return over the last 12 months was 14.8%, according to Lipper. That beat the return of 13.7% earned by the average small-stock mutual fund.
Of course, bonds in general have been helped by the worldwide decline in inflation and by the generally healthy global economy, which has sharply lowered the risk (at least near-term) of default by countries and companies.
What’s more, Uncle Sam appears to be moving inexorably toward a balanced budget, a movement that has already begun to reduce the Treasury’s voracious borrowing needs. Similarly, European governments will be forced to trim their budget deficits if they are serious about monetary union.
Still, the bond market’s biggest worry has always been the whims of central banks.
In the first quarter of this year, the Federal Reserve Board’s decision to raise short-term interest rates for the first time in more than two years--an attempt to slow the U.S. economy’s hot pace--boosted interest rates across the board.
Yet as soon as the economy began to slow again, reducing the likelihood of more Fed rate increases, investors rushed back to the highest-yielding, highest-risk bonds.
But with the “spread” between yields on high-risk and lower-risk bonds already so narrow, how much more can the high-risk bond categories rally? In other words, are those yields worth locking in today, or are they simply too low for a rational investor to accept?
Ernest Monrad, manager of the Northeast Investors high-yield bond fund in Boston, concedes that there are elements to the current rally that remind him of the junk bond craziness of the late 1980s--just before the market busted.
“The better the party, the worse the hangover,” he warns. So he is steering his fund’s assets into securities that have “real industrial assets behind them”--high-yield bonds of certain chemical and paper companies, for example.
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Les Nanberg, chief fixed-income officer for Massachusetts Financial Services in Boston, agrees that yields are very low on many bonds that would seem to hold significant risk in the long run. Still, he says, given the health of the global economy, “it’s hard to see where the vulnerability is” in continuing to chase high yields.
In the stock market, that’s the same argument that bolsters blue-chip issues, which remain extraordinarily popular even at very high price-to-earnings ratios.
The irony, Nanberg notes, is that because of the rally in higher-risk bonds worldwide, U.S. Treasuries “are actually starting to look like a high-yield market.”
At 6.16% now, the yield on a five-year U.S. T-note is higher than government notes of similar term in Germany (4.6%), Canada (5.3%) and Spain (5.4%), among others.
Could that spark a stampede soon into U.S. bonds? In financial markets, stranger things have happened.
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Average Fund Returns, by Category
Here are average total returns for key categories of bond mutual funds for the first half of 1997 and the 12 months ended June 30. Also shown is the average 12-month yield for each category. Total return includes interest earnings plus or minus any change in the bonds’ principal value. The yield is the interest return alone.
Average Total Return
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Avg. Fund category 1st half 12 months yield Emerging-market bonds +12.12% +38.7% 7.8% Convertible bonds +10.08 +17.8 3.2 Junk corporate bonds +5.92 +14.8 8.6 Multi-sector bonds +4.28 +12.9 7.6 GNMA bonds +3.37 +8.3 6.3 Lower-quality corporate +3.16 +8.9 6.3 bonds, long-term General muni bonds, +2.95 +7.8 4.9* long-term Calif. muni bonds, +2.82 +8.1 4.9* long-term High-quality corporate +2.74 +7.5 5.9 bonds, 5- to 10-year High-quality corporate +2.67 +7.7 6.1 bonds, long-term High-quality corporate +2.62 +6.6 5.7 bonds, 1- to 5-year U.S. government bonds, +2.54 +6.0 5.6 1- to 5-year U.S. government bonds, +2.50 +6.9 5.9 5- to 10-year U.S. government bonds, +2.46 +7.0 6.0 long-term Money market +2.38 +4.8 4.7 Global bonds, long-term +0.89 +9.3 6.6
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* Yield is tax-exempt, so true yield is higher
Source: Lipper Analytical Services
