Big Surprises in Much-Improved Global Bond Markets

As wild as the divergences were in the U.S. stock market in the first quarter, the global bond market wasn’t very far behind.

While U.S. junk bond prices slumped as investors ran from those higher-risk securities, emerging-market bonds had a tremendous quarter--thanks to rising commodity prices that bolstered emerging economies, including Mexico’s.

Amid the threat of a shrinking supply of long-term U.S. Treasury bonds as Uncle Sam buys back debt with the mammoth budget surplus, long-term government bond mutual funds generated strong total returns, averaging 5.3% for the quarter.

Bargain hunters also liked what they saw among many tax-free municipal bonds--even as the Federal Reserve continued to raise interest rates.

Overall, the average total returns (interest earned plus or minus change in principal value) on major bond fund categories mostly ranged from 1% to 3% in the quarter.

That wasn’t much compared with the gains in the best-performing stock sectors. But after a dismal 1999, when many bond funds posted negative total returns as interest rates rose worldwide--depressing the value of older fixed-rate bonds--the first quarter’s mostly positive returns were a welcome relief.

But can it last?

Most economists believe that the Fed will raise its key short-term interest rate, now 6%, to at least 6.5% by year’s end.

That could put more upward pressure on shorter-term Treasury securities, which already yield more than longer-term T-bonds.

The two-year T-note, for example, ended last week at 6.48%, up from 6.21% at the start of the year.

The 30-year T-bond, by contrast, ended last week at 5.84%, down from 6.48% at the start of the year.

Long-term bonds normally should yield more than shorter-term bonds. But the budget surplus is making longer-term issues scarce--or at least seem that way.

Because of that reality, “We continue to favor an overweight position in Treasuries, especially in the back end [longer-term maturities],” Merrill Lynch & Co. government-bond strategists Gerald Lucas and Joseph Shatz recently advised clients in a report.

Treasury bond funds in general could continue to perform well if global stock markets take another steep dive, experts note. That’s because money often flees to Treasuries as a “safe haven” in times of turmoil.

Similarly, tax-free municipal bonds may continue to rebound in value, after a battering late last year that pushed their yields to extraordinary levels relative to taxable yields.

What’s more, states and municipalities, flush with tax revenue thanks to the robust economy, are borrowing far less than they were a year ago via new muni bonds.

Muni bond issuance in the first quarter fell to $38 billion from $58 billion in the first quarter of 1999, according to Thomson Financial Securities Data. A lower supply of new bonds could make existing bonds more valuable to yield-hungry investors.

Perhaps the most surprising performance in the bond market has been that of emerging-market bonds.

The average emerging-market bond fund racked up a total return of 7.3% in the first quarter, according to Morningstar.

Yields on Latin American government bonds, in particular, have fallen recently as investors have taken a much more positive view of that economy’s prospects. That has boosted the value of older bonds, driving up total returns on the funds that own these securities.

In the case of Mexico, a major oil exporter, the soaring price of crude oil in the first quarter also helped increase confidence in the Mexican government.

It was only 18 months ago that emerging-market bond yields worldwide rocketed in the wake of Russia’s debt default.

Now, investors are so confident about the outlook for emerging-market borrowers that new bonds are quickly being snapped up.

Moody’s Investors Service notes that emerging-market bond offerings have surged to near-record levels: $31.2 billion in new securities have been issued so far this year, led by Latin American issuers.