Bond Funds Manage Slim Gains


What was good for stocks in the second quarter was bad for bonds.

After heady gains last year and in the first quarter as interest rates plunged--boosting the value of older, fixed-rate bonds--most bond mutual funds eked out slim total returns at best in the second quarter.

The problem: Even as the Federal Reserve continued to slash short-term interest rates to shore up the sagging economy, the bond market already was looking ahead and betting the Fed would succeed.

That sentiment drove long-term interest rates up in the quarter, in turn driving down bond values. The yield on the benchmark 10-year U.S. Treasury note, for example, has risen from 4.92% at the end of March to 5.38%.

The net effect has been to depress bond mutual fund share prices, effectively negating much or all of the interest investors earned in the period.

The average long-term government bond fund posted a total return (interest earned plus or minus share price principal change) of negative 0.8% in the quarter, according to Morningstar Inc. That followed a positive total return of 1.8% in the first quarter and a stunning 15% return for all of 2000.

Most other bond fund categories stayed in the black in the quarter, if barely. Funds that focus on shorter-term bonds fared best because their principal values fluctuate less with changes in market interest rates. Short-term investment-grade bond funds, which generally own high-quality bonds maturing in four years or less, gained 1% in total return in the quarter and 3.9% in the half, Morningstar said.

That's the important lesson for bond fund investors who fear that the economy might be booming by 2002, and that interest rates will be significantly higher by then: If that's the case, bond funds will suffer in the second half of this year, and funds that own longer-term securities could fare the worst. Funds that own shorter-term issues are likely to hold more of their value.

Better yet, investors who figure the Fed might have to turn around and start raising short-term rates by later this year may just want to keep their cash in super-safe money market funds.

Still, financial advisors caution investors against suddenly turning against bonds, especially if they just bought into them in the last year to diversify as stocks tumbled.

Bond principal values will fluctuate with market interest rates, but a diversified portfolio of high-quality bonds will be far less volatile than a portfolio of stocks. The capital-preservation aspect of bonds, relative to stocks, hasn't changed, advisors note: Bonds continually generate interest income for their owners, while stock capital gains are far more iffy.

Indeed, even with upward pressure on long-term rates, most bond fund categories still posted positive returns in the first half--while the average stock mutual fund was down 5.8%.

Over the last three years, the average annualized total return on government bond funds has been 5.4%, compared with 5.7% on stock funds, according to Morningstar. So stocks earned slightly more--but investors took a lot more risk in stocks than in bonds for that meager extra return.

The biggest disappointment in the bond market this year and over the last three years has been the corporate "junk" sector. That also happens to be one of the most popular bond fund categories with individual investors, who have been lured by the sector's high yields.

The souring economy has caused default rates on these below-investment-grade issues to rocket over the last year, led by bonds of troubled telecommunications companies. That has depressed the prices of junk bonds across the board, even of securities issued by companies that aren't in financial jeopardy.

Despite paying average annualized yields above 11%, the typical junk bond fund had a negative total return of 2.5% in the second quarter, Morningstar said. Over the last three years, the annualized total return is a negative 2.7%.

But many bond market pros argue the junk market can only improve from here--assuming the Fed's credit-easing campaign spurs an economic recovery.

Ironically, at the opposite end of the return spectrum this year is another high-yield, high-risk category: emerging-markets bond funds. They have scored strong gains amid a surge in value of Mexican government bonds and certain other emerging-market issues.


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 beginning on S8.

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