Risk Delivered Its Reward This Time for Bond Funds

Thanks to a robust U.S. economy and diminished worries about the rest of the world, risk-taking became fashionable once again in the first quarter of 1999. And yield-seeking fixed-income investors were rewarded for their courage.

Mutual funds that invest in high-yielding junk bonds or emerging-markets debt led all other fixed-income categories in the quarter.

At the other end of the spectrum, U.S. government bond funds were losers, as that same strong economy pushed up yields that had tumbled last year.

Through March 31, the average emerging-markets bond fund delivered a total return of 4.5%, while junk bond funds gained 2.6% on average. Total return is interest income plus or minus any change in the fund’s principal value.

Some individual junk bond funds did considerably better than the average. Legg Mason High-Yield was up 11.3% for the quarter while Eaton Vance Income Fund of Boston Class A was up 6%.

Beginning late last summer, worries about global recession triggered a dramatic sell-off in high-risk bonds worldwide.

Economic slumps cause investors to bail out of junk bonds and emerging-market bonds because those bond issuers are the most likely to default in times of trouble.

But in the fourth quarter, high-risk bonds rebounded sharply. That continued in the first quarter, even though Brazil’s currency devaluation in early January briefly fanned global-slowdown concerns again.

“You really got paid for the risk this quarter,” says Martin Fridson, Merrill Lynch’s director of high-yield strategy. Indeed, “the lowest-quality bonds within the high-yield sector did the best.”

That was the case even as interest rates on other bonds--especially Treasuries--rose in the quarter.

The yield on the benchmark 30-year Treasury bond ticked up more than half a percentage point during the quarter, from 5.09% at the end of 1998 to 5.62% at the end of March.

A fixed-rate bond’s price moves in the opposite direction of market interest rates. When rates fall, as Treasury yields did last year, the price of older bonds that carry higher fixed yields rises.

But when market rates go up, older bonds fall in value because their yields aren’t as rich as what investors can find in new bonds.

However, because junk bond yields are considerably higher than Treasuries to begin with, they’re not as sensitive to general changes in rates--thereby making them relatively popular in times of rising rates overall and strong economic growth.

For government bond funds, meanwhile, the quarter was a loser. As rates went up those bonds tumbled in value, reversing a yearlong “flight to safety” that drove Treasury prices up and yields down.

The typical fund that invests in long-term government debt sank 3.3% for the quarter. The typical intermediate-term government bond fund fell 0.6%, and the average short-term government bond fund rose just 0.3%. Again, those are total returns.

“Valuations for high-quality government debt reached extreme levels in the third and fourth quarters of 1998,” says Dave Schroeder, senior portfolio manager in charge of American Century Funds’ government debt. “The premium paid in terms of high prices and low yields was wrung out in the first quarter of this year.”

High-quality corporate bond funds didn’t fare much better. Long-term corporate bond funds fell, on average, 0.6% for the quarter; intermediate-term bond funds lost just as much.

Tax-free municipal bond funds, which have been attracting increasing amounts of new money in recent months, held up better than Treasuries. Both long-term and intermediate-term municipal bond funds rose 0.5%, on average.

And while emerging-market bond funds (which hold debt of countries such as Mexico and Brazil) had a strong quarter, international bond funds--which tend to hold debt of major foreign countries--lost an average of 2.1% in the quarter.

A strong dollar depressed returns on European bonds in general.

Can junk bonds and emerging-market portfolios keep their momentum? That will depend on the global economy’s health in the near term.

Arguably, both sectors are still depressed: Both junk and emerging-markets bond funds have lost money as measured over the last 12 months, because yields on those bonds still are above their levels of a year ago.

The average junk bond fund’s total return over the last year was a negative 2.1%.

Income Strategies

The “Strategies for Income-Oriented Investors” panel at The Times’ third annual investment conference May 22-23 at the Los Angeles Convention Center will focus on some of the best ways to maximize your income investments today within the limits of your risk tolerance. Call (800) 350-3211 for conference information, or see S19.