Bonds Again Set to Outdo Stocks

Corporate scandals and falling stock prices spurred a “flight to quality” that helped government bond mutual funds outperform most other fixed-income categories in the second quarter.

On the other end of the spectrum, corporate junk bond funds were hammered as investors’ appetite for risk diminished sharply.

Funds that invest in long-term government securities posted an average total return of 4.8% for the quarter, according to Morningstar Inc. That return counts interest earned and principal appreciation.

Older bonds rose in value as the benchmark 10-year Treasury note yield slid from 5.40% to 4.80% during the three-month period.

Treasury bond yields fell in part because investors lost some of their conviction that the U.S. economy is rebounding strongly from recession, and they sought Treasuries as a shelter.

Reports in the quarter gave a mixed view of the U.S. economy’s health, and many analysts pushed back to the fourth quarter or even later their estimate of when the Federal Reserve would begin raising short-term interest rates.

But perhaps an even greater reason for the rush to Treasuries was the crisis of confidence on Wall Street, which made paper backed by Uncle Sam look all the more appealing. A string of charges against executives, accounting blowups and fraud investigations soured investors on stocks. The Standard & Poor’s 500 index’s total return was a negative 13.4% in the quarter.

What was bad for the stock market also was bad for junk bond funds, which invest in bonds of firms with the weakest credit ratings. The average junk bond fund’s total return was a negative 4.6% in the quarter. The sector suffered another blow as conditions in the telecom industry--which issued tens of billions in corporate debt in recent years--continued to worsen.

Higher-quality corporate bond funds fared well in the quarter, with long-term investment-grade funds posting an average total return of 2.5%. Municipal bond funds also had strong returns.

International bond funds led the pack with a 6.7% average gain, as a weak dollar boosted the value of overseas returns.

Halfway through 2002, high-quality bonds are poised to outperform stocks for the third year running, drawing the attention of investors who have spent the last decade firmly committed to stocks.

But experts said investors eyeing bond funds should know the risks: If interest rates in general begin to rise later this year or in 2003, bond returns could suffer.

Rising market rates depress the value of older bonds. So fund investors still will be earning interest income, but their share values will fall in a rising-rate environment.

Still, interest earnings mean high-quality bonds provide the kind of cushion for a portfolio that stock funds can’t. And funds that invest in shorter-term or intermediate-term bonds generally have lower risk of principal loss because of interest rate swings.

Investors stepping into bond funds should seek out managers whose objectives and risk tolerance match their own, experts said.

And when checking a fund’s performance, “make sure the guy who generated the returns is still running the fund,” said Alan Papier, a senior analyst with Morningstar.

For most investors, the best bond funds are diversified and give their managers great flexibility to use sophisticated strategies, Papier said. He particularly likes the Los Angeles-based FPA New Income fund, an intermediate-term bond fund managed by Bob Rodriguez.

Rodriguez has cut the average maturity of his holdings to about two years in anticipation of higher rates, Papier said. The fund’s total return in the first half was 5.8%.