Bond Funds Still a Worthy Investment?

Bond mutual fund investors mostly suffered through another losing period in the fourth quarter of 1999 as market interest rates continued to rise, producing the worst calendar-year performance for bond funds since at least 1994.

And just as in 1994, last year’s bond turmoil is likely to prove a lasting lesson for many fund owners: More will have to decide if it’s bonds they don’t need--or just bond funds.

While much of the stock market ignored the rising interest rates that accompanied the economy’s boom in ‘99--and three Federal Reserve increases in short-term rates--the response in the bond market was automatic, as always.

As market rates rise, the value of older bonds paying lower fixed rates naturally declines. Even though you continue to earn interest on a bond, the security itself is worth less in the market.

And the longer a fixed-rate bond’s term to maturity, the bigger the decline in value in the face of higher interest rates.

Hence, the average long-term U.S. government bond fund posted a negative “total return” of 7.4% in 1999, according to Morningstar Inc. Despite earning a yield of about 5.3% for the year, the average fund saw those earnings more than wiped out by the drop in its principal value.

Among other bond fund categories the losses were less severe, but painful nonetheless:

* The average long-term municipal bond fund had a negative total return of 4.8%.

* Long-term investment-grade corporate bond funds posted an average negative return of 2.8%. The damage was lessened in part by the bonds’ higher yields compared with Treasuries.

* True to form, funds that own bonds maturing sooner rather than later recorded smaller losses or managed to post positive, albeit modest, total returns.

The average short-term government bond fund, for example, eked out a 1.6% total return, as principal losses failed to completely wipe out their 5%-plus average yields.

* Junk corporate bond funds, boasting yields averaging nearly 10%, also finished with positive returns overall, averaging 3.7%.

* The only standout sector: funds that own emerging-market bonds. That group’s total return averaged a positive 26.3%, a spectacular figure that reflected recoveries in foreign economies that boosted confidence in their bonds.

For U.S. bonds, the problem was more than the Fed’s rate increases.

Analysts had expected fears over the Y2K computer bug to drive many investors into the relative safety of Treasury securities in 1999, pushing yields lower.

Instead, the opposite occurred: Investors continued to pour into high-risk securities such as technology stocks.

By the end of 1999 the yield on the bellwether 30-year Treasury bond stood at 6.48%, up from 6.05% at the end of the third quarter and 5.09% at the start of the year.

While that hurt any investor who owns lower-yielding bonds, there’s another side to the story: If you’re looking to buy bonds now, you can pick up the fattest yields since late summer of 1997.

At 6.5%, government bonds aren’t exactly offering Internet-stock-style returns. Still, unless you believe market rates are headed dramatically higher in 2000, this could be a good time for nervous stock market investors to start thinking about salting some money away in safer places.

But should you buy bond funds--or individual bonds?

Though it’s true that bond funds offer you additional safety through diversification, they also impose an additional risk.

That risk stems from the fact that most bond funds trade in and out of securities, rather than hold a set portfolio of them to maturity.

By trading bonds before they mature, bond fund managers may be able to generate greater returns for shareholders--if they call market interest rate turns correctly.

However, because bond funds’ holdings fluctuate, and because there is no fixed maturity date for a bond fund, it’s possible for your fund’s share price to decline, and never recoup its losses, especially in a time of rising interest rates.

By contrast, owners of individual bonds don’t face that problem: If you own an individual bond, you know you’ll get the bond’s face value ($1,000) returned to you at maturity, barring a default by the issuer (which, of course, isn’t a risk with Treasury bonds).

After the surge in interest rates in 1994, many government-bond fund investors cashed out. Financial planners say many of their clients who owned bond funds simply opted to build their own portfolios of individual bonds, if they could.

But for some investors, funds may still be the logical way to own bonds, despite the principal risk.

The funds often allow you to invest as little as $500 or $1,000 at a time. Though you can purchase U.S. Treasuries directly from a Federal Reserve bank or branch for as little as $1,000, realistically it takes about $50,000 to build a diversified and cost-effective portfolio of bonds, according to a recent study by the Charles Schwab Center for Investment Research.

The funds also may be the best choice for bonds that are much tougher to evaluate on your own, and which can be far riskier in terms of the chances of default--especially junk corporate issues.

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Paul J. Lim can be reached at paul.lim@latimes.com.

Top-Rated Bond Funds

Bond funds, ranked according to a system developed by The Times and fund tracker Morningstar Inc. , are listed in more than a dozen categories on S15.