Bond Funds Look Appealing--but Consider the Type

Here’s a switch: Most categories of bond mutual funds outperformed most stock fund categories in the second quarter.

As many investors opted for safe havens amid global economic turmoil, most bond funds delivered--posting average total returns of between 1.3% and 2.2% in the 13 weeks ended Friday, according to fund tracker Morningstar Inc. in Chicago.

It wasn’t much, but it was better than losing heavily in Asian, Latin American and U.S. small-stock funds.

Bond funds have grown in popularity as investment options over the last two years, as more investors have sought to hedge the risk in the high-flying U.S. stock market with a less volatile, yield-paying instrument.

But with U.S. bond yields overall near 30-year lows--and clustered in the mid-single digits--is it worth spending much time deciding which type of bond fund to own?

In a word, yes.

While fixed-income funds are far more homogeneous as a group than stock investments, they nevertheless vary plenty in terms of performance, risks, expenses and taxability.

At one extreme, you will find foreign, high-yield and long-term Treasury bonds, which can be as volatile as stocks.

At the other extreme are money market funds, which have little more risk than bank accounts.

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Although many investors start their research efforts by shopping for funds paying generous yields, a better approach is to focus on volatility. One key rule of thumb is as follows: The more a bond or bond fund yields, the riskier it probably is, in terms of the potential movement of its share price.

A corollary is that funds that invest in longer-term bonds tend to yield more while subjecting investors to greater potential swings in value. But for investors who plan to hold bond funds indefinitely, and who are focused on the regular income they provide, short-term swings in fund share price may be a less significant consideration.

If you couldn’t stomach any losses or are saving for a specific near-term goal such as buying a car or house, stick with money market funds, which maintain a steady $1-a-share price, or short-term bond funds.

Money market stability is ensured not by any sort of federal deposit guarantees but rather by the great variety and types of instruments held in them. The funds invest in Treasury bills, certificates of deposit and highly rated corporate IOUs with near-term maturities. The short-term, high-quality nature of these investments lessens principal risk. Only one money fund has ever suffered a loss, and that was a small portfolio not open to retail customers.

“People really shouldn’t worry since money funds are so heavily regulated,” said Peter Crane, managing editor of the IBC Money Fund Report in Ashland, Mass.

A particularly strong case can be made for money market funds currently since they’re yielding nearly as much as bond funds without the extra risks attached.

For example, taxable money funds are yielding just under 5% on average, according to the IBC Money Fund Report.

By contrast, five-year U.S. Treasury notes are yielding about 5.5% now, so many short- and intermediate-term U.S. government bond funds will have current yields, after fund expenses, of about 5%.

“We’re in an unusual situation where interest rates are mostly unchanged across the maturity spectrum,” said Brad Tank, director of fixed-income investing at Strong Funds in Milwaukee.

You can get higher yields on longer-term government funds and on investment-grade corporate bond funds. But again, the higher the yield, the more risk to your principal value if market interest rates should soar, automatically depressing the worth of existing fixed-rate bonds.

The flip side is that longer-term bond funds would be a natural bet for investors who believe that long-term yields will continue to fall.

That could occur if the U.S. economy were to slow significantly in the months ahead. With inflation subdued, there is plenty of room for yields to fall, some analysts say.

The catalyst for a slowdown in the U.S., and thus even lower interest rates, could be recession-plagued Japan and its sluggish currency.

“Thanks to collapsing Asian economies, the United States economy will finally start slowing,” predicts economist Don Hilber at Norwest Corp. in Minneapolis. “Weaker trade will curtail job and income growth, which in turn will impact consumer spending, business investment and inventory accumulation.”

Tank agrees and points out that interest rates typically decline late in the economic cycle as business activity itself slows. U.S. interest rates, he adds, are higher than those in Japan and several key European nations and thus may have room to fall on a relative basis.

Also, U.S. bonds, especially Treasuries, have benefited from a “flight to quality” in global capital markets. The greater demand for the bonds also depresses interest rates. And as the dollar has gained strength against foreign currencies, especially the Japanese yen, U.S. debt becomes more attractive.

But if the economy is going to slow, one bond fund category could be troubled: high-yield junk bonds. That category, in fact, posted a total return of just 0.2% in the second quarter through Friday, which means the high yields on the funds barely offset the decline in the bonds’ values as some investors sold out.

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Bond Fund Performance by Morningstar Category

Here are average total returns for bond mutual fund categories tracked by Morningstar, through Friday. Total return is dividend or interest income plus or minus any principal change. Figures for periods longer than one year are annualized average returns. Category descriptions, and Morningstar’s top-rated picks by category, appear in the tables on the next few pages.

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Annualized Category 13 weeks YTD 1-yr 3-yr 5-yr Long-term government 4.1% 5.4% 19.1% 9.1% 8.0% Intermediate-term inv. grade 2.2 3.6 9.5 7.2 6.4 Long-term inv. grade 2.1 3.7 11.1 8.7 7.8 Intermediate-term government 1.9 3.2 9.1 6.7 5.7 Short-term inv. grade 1.6 3.0 7.0 6.2 5.4 Short-term government 1.4 2.6 6.6 5.8 5.0 Ultrashort-term 1.3 2.5 5.5 5.7 5.2 Long-term municipal (natl.)* 1.3 2.3 8.4 7.0 5.9 California municipal* 1.3 2.2 8.0 7.1 5.9 Interm.-term muni. (natl.)* 1.2 2.2 7.4 6.4 5.6 High yield 0.2 4.2 11.3 12.4 10.0 Multi-sector --0.2 2.5 7.0 9.5 7.4 International --1.7 1.0 3.1 9.3 6.2

Category 10-yr Long-term government 10.0% Intermediate-term inv. grade 8.6 Long-term inv. grade 9.6 Intermediate-term government 8.0 Short-term inv. grade 7.2 Short-term government 7.1 Ultrashort-term 5.5 Long-term municipal (natl.)* 7.9 California municipal* 7.9 Interm.-term muni. (natl.)* 7.3 High yield 10.2 Multi-sector 9.5 International 7.4’

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