Many Bond Funds Stabilize--for Now

In the midst of the second-worst bond market on record, and the worst since 1994, U.S. government bond mutual funds in general managed to break even in the third quarter, foreshadowing what could be a promising fourth quarter for U.S. Treasuries.

To be sure, most market interest rates continued to climb in the third quarter, spurred by two rate hikes by the Federal Reserve.

Bond prices move in the opposite direction of market interest rates, and this year’s move has hurt a number of mutual fund categories. While rising rates may attract investors to individual bonds to protect some of their stock market gains, they are detrimental to bond fund performance.

The average corporate bond fund, for instance, lost 0.1% in total returns (that’s yield plus or minus any change in principal) during the third quarter and is now down 0.1% for the year, according to Chicago-based fund tracker Morningstar Inc. The average fund that invests in long-term investment-grade corporate bonds fell 0.3% in the quarter and is down 2.6% for the year.

Yet rates on the benchmark 30-year Treasury bond, though still up year to date, began to buck this trend by inching down slightly toward the end of the quarter, from a high of 6.28% on Aug. 12 to 6.05% by Sept. 30. That helped lift the average government bond fund 0.6% for the quarter, though it’s still down 0.8% year to date.

Analysts say this could be an early sign that investors--fearing increased stock market volatility and financial market disruptions caused by the millennium computer bug--may already be taking flight to safety.

Ultra-safe Treasury bonds, which are backed by the full faith and credit of Uncle Sam, were clearly the haven of choice for nervous investors during the late-summer market slide last year.

In the third quarter of 1998, for instance, demand for Treasury bonds sent yields plummeting from 5.77% in July 1998 to 4.98% by the end of the third quarter. As a result, the average long-term government bond fund delivered total returns of 7.3% in the third quarter of 1998.

“Going into the fourth-quarter [of 1999], I’m not sure you want to be too far away from Treasuries,” said Graham Allen, who manages $46 billion of fixed-income assets at Wells Capital Management in L.A.

“I’m expecting to find some big opportunities in [government] bonds,” adds Ron Rowland, editor of the All Star Funds newsletter.

In the three months ended Sept. 30, the average short-term government bond fund gained 0.8% while the average intermediate-term government bond fund advanced 0.5%.

The promising short-term numbers belie what has been a difficult year for other bond funds. The average long-term government bond fund is down 5.4% through the first nine months of this year.

Another sign of a shift to quality? In the first half of the year, junk bond funds, which invest in low-quality but high-yielding corporate debt, were up 3.1% on average. Yet in the third quarter, demand for junk bonds waned as default rates rose, driving junk yields up from 9.7% to 10.6%. That pushed total returns for the typical junk bond fund down 1.7% in the quarter.

For the year now, the average junk bond fund is up just 1.5%, well shy of its 10-year annualized average gains of 9.2%.

The average intermediate-term municipal bond sank 0.3% in the quarter. Long-term municipal bond funds fell even more--1.5% on average during the quarter--and are now down 3.2% for the year.

Overseas, bond funds fared much better in the third quarter, with the typical international bond fund surging 1.4%, largely on the weakening of the dollar versus both the yen and the euro.

All eyes are on the Fed, which meets today to discuss whether it will raise short-term rates for the third time this year.

Typically, bonds get a second look when stocks falter, because investors believe they can earn competitive returns and because bonds generally are better than stocks at reducing downside risk.

Still, the very fact that the Fed is talking about raising rates indicates continuing fear of economic growth and inflation at home, analysts point out. And if the global economy grows, as expected, in 2000, rates worldwide should tick up, which would make it tough for most bond funds to make money.

Bloomberg News was used in compiling this report.