Bond Funds Face Challenges, but May Still Eke Out a Positive Year

After two strong years, bond mutual funds lost some of their luster in the first quarter as market interest rates rose in anticipation of an economic rebound and the Federal Reserve moved one step closer to reversing its easy-credit policies.

Investors in funds that own longer-term Treasury securities mostly saw their funds lose value in the quarter, though the losses were small.

Funds that own corporate bonds generally fared better, and that could be the story all year: Many experts believe 2002 could prove profitable for holders of corporate debt, including high-yield junk bonds, which are those considered less than investment grade.

And even if interest rates continue to rise, depressing older bonds’ values, Treasury and tax-free municipal issues should remain a portfolio cornerstone for many conservative investors, financial advisors say.

While acknowledging that the recession is over, bond proponents argue that the economic recovery is likely to be muted, with businesses growing slowly as they focus on repaying debt and cutting costs. That could mean that interest rates would rise slowly and that many companies’ finances would improve, decreasing default rates on corporate bonds and boosting the appeal of those issues.

If that scenario plays out, “I actually think this could be the third consecutive year where bonds outperform stocks,” said Mark Kiesel, senior investment strategist at Newport Beach-based bond fund manager Pimco.

So far this year, though, many bond funds are struggling. After 11 Fed cuts in short-term interest rates in 2001, longer-term rates began rising late last year and continued rising during the first quarter as evidence of an economic rebound began to pile up.

The yield on the benchmark 10-year Treasury note, for example, rose from 5.05% on Dec. 31 to 5.39% by the end of March. The yield has since slipped back to 5.21% as of Friday.

When market rates rise, the value of older, lower-yielding bonds drops. In the first quarter, the declines in bond mutual fund share prices almost exactly offset interest earnings in the period on the typical government and corporate fund, according to fund tracker Morningstar Inc.

Some cheering was heard from investors bold enough to own funds that invest in emerging-markets debt. Those funds scored an average return of 6.7% in the quarter, as emerging-market stocks, such as in Mexico, also rallied.

But the average corporate bond fund posted a total return--interest earnings plus or minus any change in principal value--of just 0.2% in the quarter, Morningstar said. The average government bond fund finished with a zero return.

By contrast, as interest rates fell in 2000 and 2001, investors in government bond funds enjoyed average total returns of 10.4% and 6.7%, respectively, as declining rates boosted the value of older bonds.

Bonds’ strong performance prompted heavy flows of cash into bond mutual funds last year. The inflows continued early this year, with nearly $30 billion in net new cash flowing into bond funds in January and February, according to the Investment Company Institute, the funds’ main trade group.

Even as bond fund returns sputter this year, some experts said there’s no reason for investors to flee bonds if their goals are the classic ones of gaining a reliable stream of income or diversifying a stock portfolio.

In fact, as interest rates rise, buying new bonds can become more appealing: The 10-year Treasury note’s yield now is about 4 percentage points above the current inflation rate. If inflation stays tame, the Treasury note’s yield is providing a historically high “real” (after inflation) return.

Using bonds to help anchor volatile stock portfolios remains a nearly universal practice among financial planners, even among those like Laura Tarbox of Newport Beach, who believes now “is probably the worst time to invest in bonds in our lifetimes” because higher interest rates are so likely.

“However, one never knows for sure, and we believe in diversification,” she said. Tarbox keeps portfolios of even growth-oriented clients at least 16% in cash and fixed-income securities. For Tarbox these days, that means mostly mortgage-backed securities and corporate bonds with shorter maturities because they lose less value than longer-term bonds when interest rates rise.

Even in bad years for bonds, as when the Fed doubled short-term interest rates in 1994, the damage to bond funds is generally modest compared with what can happen to stocks.

The average share-price decline of long-term government bond funds was 10.4% in 1994. But that was partly offset by interest earnings that year, so the total return on the funds was a negative 4.6%, according to Lipper Inc.

In the stock market, a bad year can mean losses of 20% or more.

“If you’ve lived through the stock market the last couple of years, you’ll never have any damage like that” in bonds, said Ross Gerber, chief operating officer of Independent Capital Management in Woodland Hills. “With bonds, it’s a much safer place to play.”

Here’s a look at last quarter’s performance of key bond market sectors and the current outlook.

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Treasuries

When the yield on the benchmark 10-year T-note jumped from 4.8% to 5.4% in just two weeks last month, it was a harsh reminder of how fast the outlook can change for bondholders in a rebounding economy.

The rise in market yields left the average long-term government bond fund with a negative total return of 0.6% for the quarter, according to Morningstar.

Intermediate-term government bond funds, less sensitive to rising interest rates, eked out a 0.1% positive return in the quarter, while short-term government funds returned 0.2% on average.

Should a strong economic recovery continue, and if inflationary trends such as the recent spike in oil prices persist, yields on new Treasuries could rise still higher, devaluing older bonds and sending bond fund share prices tumbling again, experts said.

“Government bond funds were the best place to be last year, but I think you can potentially lose a lot of money on them this year” relative to other types of bonds, said Gerber. He has been advising clients to jump from Treasuries to corporate bonds.

But believers in a slow economic recovery say that, for guaranteed income that outpaces inflation, Treasuries remain a good choice.

At Western Asset Management in Pasadena, chief economist Scott Grannis said the markets already are assuming that the Fed “is going on the warpath” and will push its key short-term rate from 1.75% now to 3.5% by year’s end.

“That’s an awful lot of tightening in a zero-inflation world,” said Grannis, who thinks a year-end Fed rate of 2.5% is more realistic. If he’s right, longer-term yields may not rise significantly this year.

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Corporate Bonds

Total returns on investment-grade corporate bond funds were uninspiring in the first quarter--intermediate-term funds were down 0.3% and long-term funds lost 0.5%.

Junk-bond funds, after posting an average total return of 5.5% in the fourth quarter, were up 0.9% in the first quarter, which means their high interest earnings were mostly offset by declining principal values.

Corporate bond investors have had plenty of worries: the recession, terrorist attacks, record public-company bankruptcies and fears of Enron Corp.-style hidden debts. But considering the improving economy, aggressive corporate cost-cutting and their current yields, corporate bonds are a great choice, said portfolio manager Stephen Kane of Metropolitan West Asset Management in Los Angeles.

The average 12-month yield on intermediate-term investment-grade bond funds is about 5.4%, compared with about 4.9% on intermediate-term government bond funds, according to Morningstar.

“The market is pricing in an excessively pessimistic outlook for corporate profitability and insolvency,” Kane said. “We think within a year’s time, some of these fears will have abated due to the stronger economy and better balance sheets.” He recommends focusing on intermediate-term or shorter-term corporate bonds, however, to help limit losses if interest rates accelerate.

Many analysts believe that junk bonds could be poised for a great year. That was the case in 1991, when the economy was recovering from the 1990 recession. The average junk bond fund posted a total return of 37.1% in 1991 as market rates fell and waning worries about defaults pushed junk bond values sharply higher.

But the risks of owning junk bonds remain high. If the economic recovery slows, corporate bankruptcies and junk bond defaults could rise again.

Unlike some analysts, Pimco’s Kiesel is staying away from junk bonds. He prefers BBB-rated corporate bonds--the lowest level of investment grade--arguing that the sector has been overlooked by cautious investors and speculators who’ve been focusing on junk.

Another alternative for investors looking for higher yields, he said, is mortgage-backed bonds, which will run much less danger of early repayment as modestly rising interest rates rein in last year’s refinancing spree.

Many major mutual fund companies offer funds that invest in Government National Mortgage Assn. (GNMA, or Ginnie Mae) bonds. Morningstar’s top-rated GNMA funds are listed in government-bond categories on page U10.

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Municipal Bonds

Anyone who can afford California’s high housing costs, contribute to tax-sheltered retirement plans and still have money to invest probably is in a high enough tax bracket to consider tax-exempt bonds issued by state and local governments and agencies. And so-called munis are always a favorite of retirees and others looking for safe returns.

Compared with other bond categories, municipal bond funds held up relatively well in the first quarter, according to Morningstar. Funds that invest in long-term California municipal bonds broke even, on average, but returns on other municipal fund categories ranged from 0.3% to 0.8%.

Two years ago, investors were complaining of a shortage of muni bonds, but there’s an abundance these days.

“California is on the verge of a bond explosion unlike any we can remember,” wrote Zane B. Mann in his latest California Municipal Bond Advisor newsletter, which is published in Palm Springs.

Borrowing is accelerating for public-works projects, for example. California also is planning a mammoth bond offering to cover the costs of last year’s electricity crisis.

Greater issuance of bonds will give investors more choices. Many municipal bond investors prefer to own individual securities rather than funds, because individual bonds guarantee a set interest rate and full return of principal at maturity.

But Gerber contends that individual investors don’t have access to the best municipal bonds, so he still recommends buying funds. What’s more, investors have to be careful when buying bonds of smaller municipalities. Though municipal bond defaults are rare, when they do happen it usually involves small issues.

Traditionally, bonds issued directly by California (so-called general obligation bonds) have paid a quarter-point or so less in interest than those of other states because of strong demand for California issues. But stresses from last year’s power crisis and economic slowdown, along with an increasing debt load, have lifted California municipal yields more in line with other states’.

Even so, California still is in good position to support its debt load, Mann said, based on the criteria used by bond-rating firms, such as debt load per capita. And at current yields, nvestors in higher tax brackets can earn attractive returns on municipal issues relative to U.S. government bonds or corporate bonds.

For example, a recently issued California bond maturing in nine years was priced to yield 4.52% a year, Mann said. That yield, exempt from both federal and California income tax, is the equivalent of an 8.21% taxable bond yield for someone with a combined federal and state tax rate of 45%.