High-Quality Bonds Shine in Rush to Safety

In the bond market, there was no substitute for quality in the third quarter--continuing a trend that took hold in the spring.

Mutual funds that focus on long-term U.S. government bonds racked up strong returns in the quarter ended Sept. 30 as fearful investors rushed into Treasury securities, pushing yields down to 40-year lows.

That made older, higher-yielding bonds more valuable, driving their prices up. The result was an average total return (price change plus interest earned) of 7.9% for long-term government bond funds in the quarter, according to Morningstar Inc.

Other high-quality bond categories also benefited from investors’ hunger for relative safety, as stocks fell to multiyear lows, the economic recovery appeared to falter and President Bush threatened war with Iraq. Municipal bond funds and investment-grade corporate bond funds generated total returns in the 2% to 5.5% range in the quarter.

As usual in a period of falling market interest rates, longer-term bonds performed better than shorter-term issues.

In general, bonds continued to shine at stocks’ expense. Most bond fund categories gained 5% to 12% in the nine months, according to Morningstar.

In contrast, the average domestic stock mutual fund plummeted 26.7% in the period.

In the three years ended Sept. 30, government bond funds produced an average annual return of 8.4%, while stock funds lost 8.5% a year in the same period, Morningstar said.

Bonds’ healthy returns during stocks’ long bear market have taught many investors an important, if belated, lesson about the wisdom of portfolio diversification.

But with Treasury bond yields at generational lows--the 10-year T-note yield was at 3.67% on Friday, down from 5.05% at the start of the year--the big question now is whether yields are primed to rebound over the next year. If that happens, bond prices would sink and bond fund returns could go negative.

Many bond market pros are worried by what they say has been almost panicked buying of Treasuries in recent months. “Extreme bullish bond sentiment,” read the headline on a report last week from investment firm Bridgewater Associates Inc. in Wilton, Conn.

The fear is that yields could whiplash if economic data begin to point to a sustained recovery and/or if the United States decides against going to war with Iraq.

What’s more, experts note that some of the demand for high-quality bonds in recent months has been tied to technical factors. For example, the surge in mortgage refinancings has led to earlier payoffs of mortgage-backed bonds, driving some portfolio managers and traders to lock in yields on Treasury bonds instead.

That demand could dry up if market interest rates begin to rebound.

Noting the large cash inflows into bond mutual funds in recent months, some market pros fear that investors are loading up at what could be the low point for bond yields for years to come.

“Big flows happen at market extremes,” said John Mousseau, a municipal bond portfolio manager at Cumberland Advisors in Vineland, N.J. “Which is why, on a big-picture basis, we’re constructive on equities and very cautious on bonds,” he said.

Still, analysts note that warnings about bonds, particularly Treasury issues, have been rampant for months but the market continues to rally.

“Everyone believes the Treasury buying is overdone, but it shows you there is nearly zero risk appetite, and I don’t see that unwinding,” said Gregory Peters, a credit strategist at brokerage Morgan Stanley in New York.

What could keep bond yields at current levels into 2003, or drive them even lower? If the economy weakens, forcing the Federal Reserve to cut short-term interest rates again, high-quality bonds almost certainly would benefit, analysts say.

War with Iraq also could increase demand for safe-haven securities. Likewise, if the stock market continues to tumble, high-quality bonds may be the natural beneficiaries.

But with Treasury bond yields at such low levels, many long-term investors probably will be looking at other, higher-yielding securities--especially investment-grade corporate bonds and tax-free municipal bonds, analysts say.

“I don’t think in three years you will see rates lower than they are now,” said Joe Jackson, who helps invest $3 billion for BB&T; Asset Management in Raleigh, N.C. Even so, at current yields, “high-quality corporates look like a very attractive place over the longer term,” he said.

Corporate bond mutual fund managers, however, have to be careful in their bond-picking, given the number of big-name firms that have spiraled into bankruptcy protection over the last year--such as Enron Corp., WorldCom Inc. and Adelphia Communications Corp.

“You really have to scrub the names and buy something you’re comfortable with,” Jackson said.

Quality concerns are less pronounced in the municipal bond market, where defaults are far rarer. That has helped stoke demand for muni issues, even though yields have dropped sharply this year.

A Moody’s Investors Service index of high-quality 10-year municipal bonds yielded an annualized 3.4% as of last week, down from 4.5% at the start of the year.

Because muni yields are tax-exempt, the true returns are higher. A California muni bond yielding 3.4% would be equivalent to a fully taxable bond yielding 5.35% for a California investor in the combined 36.5% federal and state combined tax bracket (for married couples, that bracket begins at taxable income of about $113,000).

With 10-year Treasury yields at 3.67%, a true yield of 5.35% on a 10-year muni is considerably more attractive, analysts note.

The segment of the bond market that continues to vex many investors is the corporate junk-bond sector. The average junk bond mutual fund lost 3.6% in the third quarter and is down 7.3% year to date, according to Morningstar.

Soaring default rates among junk issuers have kept many investors away from the sector, despite yields that are near 10-year highs.

“Investors seem to be on strike against any assets perceived to carry a high risk premium,” said Kingman Penniman, head of high-yield research firm KDP Investment Advisors Inc. in Montpelier, Vt. KDP’s index of 100 junk issues now yields 11.98%.

If and when the economy is shown to be in a sustained recovery--and stock prices with it--junk bonds should rally, bond market pros say. But when that will happen is still an open question.

Because many junk-bond-issuing companies will need to raise capital in the stock market in the long run, “in order for high-yield to perform, the stock market has to be at least stable, if not strong,” said Brendan White, a senior portfolio manager who invests $1.1 billion for Fort Washington Investment Advisors in Cincinnati.