Long-Term Treasury Bonds Once Again the Belle of the Ball

Many investors fell back in love with bonds in a big way in the third quarter, as the stock market sank.

But for the most part, it was long-term U.S. government bonds they wanted--producing stellar returns for mutual funds that own those issues.

The question for the fourth quarter is whether other bond fund sectors might begin to attract more attention as well.

As world stock markets, from Asia to Russia to Latin America, toppled in succession throughout the quarter, investors flocked to bonds issued by what they expected would be the last domino standing: the U.S. government.

Scurrying for safety over yield, investors poured money into government and Treasury bond funds with a vigor not seen since 1994.

At the same time, they virtually ignored higher-yielding but riskier portfolios that invest in corporate junk bonds and emerging-market debt.

It was a classic “flight to quality,” said Lyle Fitterer, co-manager of the Strong Advantage bond fund.

But in addition to fear, there was a strong component of greed.

“Money flows out of things that aren’t performing well and into things that are,” said Greg Schultz, a principal with Asset Allocation Advisors in Walnut Creek, Calif.

And government bond funds performed better this quarter than any other category of funds tracked by Morningstar Inc.

As panic buying drove the yield on the benchmark 30-year Treasury bond to historic lows of less than 5%, older fixed-rate bonds rose in value. That helped long-term government bond funds generate stock-like total returns of 7.3% during the third quarter. Year-to-date, these funds are up 13.3%. (Total return is interest income plus or minus any change in the principal value of the bonds.)

Most bond fund sectors posted positive total returns in the quarter as well--if not as great as long-term Treasuries.

Of the 20 fixed-income fund categories tracked by Morningstar, for instance, 17 were up during the third quarter, marking the second straight quarter that bond funds outshined stocks.

In addition to government bond funds, intermediate- and short-term investment-grade corporate bond funds have done reasonably well for the year.

“With low inflation, low commodity prices and global uncertainty, we’re in a very bond-friendly environment,” said Dianne Sales, lead manager for the John Hancock California Tax-Free Income Bond fund.

And now that it appears that the Federal Reserve Board--which cut short-term interest rates Sept. 29--might cut them further in the months ahead, interest rate risk appears low for the moment.

Going forward, though, what might be an issue for some bond funds--at least other than those that invest in U.S. government debt--is so-called credit risk.

In addition to moving in the opposite direction of market interest rates, bond prices are affected by the health of the issuing company or government.

A corporate junk bond, for instance, will lose value if prospects of the underlying company defaulting on its debt increase.

Similarly, a municipal bond will lose value if concerns arise about the fiscal health of the underlying municipality.

Obviously, in the event of a recession, the financial well-being of some bond issuers could be threatened, lowering the value of their bonds.

That could affect fund flows into the following three bond fund categories, analyst say:

* Emerging-markets bonds. These portfolios were the big losers among fixed-income funds during the third quarter, plunging, on average, 31% in the 13 weeks ended Sept. 30.

They were hurt by safety concerns and by currency devaluations.

So long as Asian and Latin American countries (not to mention Russia) continue to have problems meeting their obligations, the prospects that investors (and profits) will return to this sector are slim, analysts say.

* High-yield (junk) bond funds. Junk bond funds had been among the most popular bond fund categories during the last three years, as investors saw these high-yielding instruments as stock alternatives.

That all changed during the third quarter, when junk bond funds lost, on average, 8% (in total return) and investors seeking to limit risk and raise cash pulled a net $3.3 billion from these funds.

“We have a liquidity crisis in the high-yield market,” said Arthur Calavritinos, lead manager of the John Hancock High Yield fund.

In a recession, high-yield-fund managers say all bets are off--the sector is likely to take an even bigger hit.

But shy of a recession, managers note the relative attractiveness of junk bonds, as their yields are now higher than they’ve been, relative to 10-year Treasury bonds, since 1996.

* Municipal bond funds. The story for tax-free muni bond funds, which gained about 3% during the quarter, on average, is actually quite compelling, muni bond fund managers say.

Currently, yields on insured, high-quality, long-term municipal bonds stand at just under 5%--virtually equal to that of Treasuries.

That might seem low in a taxable bond fund, but because muni income is tax-free, the real yields are much higher: For investors in the top 39.6% federal tax bracket, that’s the equivalent of getting an 8.3% yield.

“We have not seen this type of value in the muni bond market since 1986--in over a decade,” Sales said.

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Bond Fund Performance by Morningstar Category

Here are average total returns for bond mutual fund categories tracked by Morningstar, through Sept. 30. 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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Obj Total Return Annual Category Cat 3rd Q YTD 3-yr. Long-term U.S. government LG 7.3% 13.3% 10.8% Intermediate U.S. government IG 3.9 7.3 7.5 Intermediate-term invest. grade CI 3.3 7.2 7.9 California municipal MC 3.3 5.7 7.7 Short-term U.S. government SG 3.1 5.9 6.4 Long-term municipal (national)* ML 2.9 5.3 7.7 Intermediate-term muni (national)* MI 2.8 5.1 6.6 Short-term investment grade CS 2.7 5.9 6.6 Ultrashort-term UB 1.5 4.2 5.5 Long-term investment grade CL 1.2 5.2 8.3 International IB 1.2 4.2 7.6 Multi-sector MB -3.5 -0.7 7.2 High-yield HY -8.0 -3.8 8.0 Emerging markets EB -31.4 -34.5 3.6

ized Total Return 12-mo Category 5-yr 10-yr Yield Long-term U.S. government 8.0% 10.7% 4.9% Intermediate U.S. government 6.1 8.2 5.6 Intermediate-term invest. grade 6.4 8.7 5.6 California municipal 5.9 7.9 4.5 Short-term U.S. government 5.4 7.2 5.3 Long-term municipal (national)* 5.8 8.0 4.5 Intermediate-term muni (national)* 5.4 7.3 4.3 Short-term investment grade 5.5 7.4 5.5 Ultrashort-term 5.3 5.4 5.4 Long-term investment grade 7.1 9.4 6.0 International 5.9 7.7 4.2 Multi-sector 6.2 9.3 7.6 High-yield 7.7 9.2 9.2 Emerging markets 2.5 NA 13.7

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* Because muni interest is tax-exempt, real returns will be higher than stated returns and will depend on an investor’s tax bracket.

Source: Morningstar