To make big money in the bond market in the second quarter and first half, investors had to abandon quality and reach for yield.
Emerging-markets bond funds led all other categories in the quarter, recording an average total return of 4.8%, according to fund tracker Morningstar Inc. By contrast, "safe" long-term U.S. government bond funds had a total return of negative 2.2% in the quarter, compounding their first-quarter losses.
Total return is the interest earned by a fund in a given period, plus or minus any change in the fund's principal value.
As investors worldwide focused on the prospects for an improving global economy in 1999, the same theme that played out in stock markets--a fresh willingness to take risks--played out in bond markets.
Emerging-markets bond funds, which last year recorded negative total returns of nearly 25%, on average, as risk-averse investors fled those securities, were back in favor in a big way. The major appeal: annualized yields of nearly 13%, on average.
Meanwhile, as the strong U.S. economy pushed interest rates higher in the second quarter, long-term Treasury bonds and municipal bonds--both considered among the safest securities--suffered. Rising market yields automatically depress the value of older, lower-yielding fixed-rate bonds.
The bellwether 30-year Treasury bond yield ended last week at 6%, up from 5.1% on Dec. 31.
U.S. junk bond funds also were hurt by rising market interest rates, but their high yields still allowed them to eke out a positive total return in the quarter, offsetting their principal losses.
General international bond funds, which typically own European or Japanese bonds, had another problem: the strong dollar, which automatically devalues foreign securities held by Americans.
With last week's decision by the Federal Reserve to raise short-term interest rates just a quarter of a point and to adopt a "neutral" stance toward further rate changes, some experts believe U.S. bond yields could stabilize or come down.
"We've come to resolution on a lot of things, and that has made this a positive time for the bond market," said Charles Ullerich, who has been buying five-year government bonds for the $2 billion he helps manage at Pilgrim Funds in Phoenix.
Others aren't so sure. "The uncertainty about where rates are going is not over yet," given the strong economy, said Paul Kaplan, who manages about $30 billion in bond funds for Wellington Management Corp. in Boston. "It will be difficult to have a significant rally in bonds soon."
Steve Michaels, who manages $650 million of bonds at Financial Management Advisors in Los Angeles, is wary of junk bonds' prospects as well. "My feeling is that the Fed is still in a tightening mood, and that's probably going to hold back gains for high-yield," he said.
In the near term, muni bonds could benefit from what is typically a heavy period of investment by muni bond owners receiving semiannual interest payments and looking to reinvest in more bonds, analysts say.
Some believe good opportunities still exist in emerging markets.
Henry A. (Hank) Frantzen, global chief investment officer for Federated Investors, thinks some of the best opportunities are in bonds of countries such as Poland, Hungary and the Czech Republic, where bonds currently are trading at yields 10 percentage points above those of U.S. Treasury bonds.
"You're being compensated for the increased risk," Frantzen said.