Bonds Beat Stocks, but There Are Caveats

The long bull market in bonds lost momentum in the first quarter as fixed-income investors were whipsawed by fluctuating interest rates.

Still, after three straight years of beating stocks -- something that last happened six decades ago -- bonds managed to do it again. Lehman Bros.’ broad index of investment-grade U.S. bonds showed a total return of 1.4% in the first quarter, compared with a 3.2% decline in the Standard & Poor’s 500-stock index.

But the pace of the bond gains has slowed markedly. Mutual funds that invest in U.S. government securities notched an average total return -- income plus price appreciation -- of 0.8% in the first quarter, according to fund tracker Morningstar Inc. By contrast, the gain was 4.2% in the third quarter of last year.

Those willing to reach for higher yields through lower-quality corporate bonds or foreign debt came out farther ahead in the last quarter, however. High-yield, high-risk junk bond funds rose 5.4% on average, according to Morningstar, while corporate bond funds averaged a 2.4% gain.

The average total return for all international funds was 4.2%, helped by foreign currencies that strengthened against the dollar and a heady 8% jump in emerging-markets funds.

The rise in junk and foreign funds represented a wager by bolder bond investors that the domestic and world economies eventually will improve, lifting the securities of struggling companies and decreasing the chances of more Argentina-style defaults on national debts.

For investors fortunate enough to have enjoyed the big bond rally, the question now is whether to take some winnings off the table. Falling market interest rates boost the principal value of older fixed-rate bonds, which is what has happened for three years.

But if interest rates begin to rise, the value of older fixed-rate bonds will decline, hurting bond returns.

“If you’ve been hiding out in bonds, you’ve done well. But now it’s time to get some of your money back in the stock market,” said Scott Grannis, economist at Western Asset Management, a Pasadena fixed-income firm with more than $110 billion in assets under management.

Bill Gross, managing director at Pimco Funds in Newport Beach, isn’t so sure. Gross thinks the Dow Jones industrial average will return no more than 5% or 6% annually in the coming years -- not enough to take the extra risk that comes with owning equities.

“At this point, I’d still rather be in an overpriced corporate bond than an overpriced stock,” he said.

Here’s a look at how the major fixed-income fund categories performed in the first quarter and where they may be heading:

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Treasuries

As long-term interest rates tumbled in 2002, the average total return on funds holding Treasury securities with maturities of 10 years or more was 13.2%. But the sector cooled dramatically in the first quarter, returning a slim 0.9% as long-term rates on March 31 stood about where they were at the start of the year.

The small change belied the jitters evident in the market, however, as war loomed throughout the quarter before finally arriving at the end.

Yields on government debt sank to 40-year lows in mid-March as reports of economic weakness and uncertainty about the U.S. standoff with Iraq sent investors again scurrying for the safety of Treasury securities. Yields spiked when the war began and the U.S.-led forces scored early successes, only to retreat again as it became clear the war would last longer than some had expected.

In its quarter-end analysis, fund data firm Lipper Inc. predicted that Treasury markets would continue “swaying aggressively with every rumor, every headline, until there is a resolution in Iraq.” For now, Lipper said, “investors are not ready to abandon safe-haven U.S. Treasuries in spite of historically low yields.”

But advisors such as Mario DeRose, fixed-income strategist at brokerage Edward Jones, urged investors to be very cautious about bonds.

When the war ends, DeRose said, attention will return to the economy and “eventually it will come around.” That will send investors into stocks, possibly rekindle inflation and move interest rates higher.

“Long term,” he said, “the gravy train’s going to end in the bond market.”

Investors worried about the damage that rising interest rates inflict on a bond portfolio can achieve some protection by focusing on short- and ultrashort-term bond funds. These funds usually suffer less than long-term funds when rates are rising while still providing better returns than money market funds.

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Municipals

Long-term municipal bond funds posted an average total return of 0.5% in the first quarter, with headlines about battered state budgets, downgrades by credit-rating firms and fears that Philip Morris USA would default on its tobacco-settlement payments all hanging over the market.

Gross thinks the concerns have been overstated: Municipal defaults, after all, are extremely rare, and yields on many municipal issues now are the same as for comparable T-bonds. Because muni yields are tax free, while investors pay federal tax on interest from Treasury bonds, the true yields on munis can be dramatically better than on other bonds.

For example, when California sells $2 billion in general-obligation bonds this month, the 30-year securities are expected to provide a tax-free yield of more than 5%, noted Zane Mann, publisher of the California Municipal Bond Advisor. That’s the equivalent of a 9% taxable yield for investors in the highest tax bracket and compares with a current yield of 4.96% on 30-year Treasury bonds.

Despite California’s budget woes, Mann recommends the state’s general-obligation bonds for muni investors who plan to hold the securities to maturity and thus aren’t overly troubled by price fluctuations. Buying mutual funds that invest in the bonds can be more problematic, however, because the funds’ holdings change continually, causing their returns to gyrate along with bond prices.

Another caveat: Because income from municipal bonds is tax-free, they are inappropriate for 401(k)s or other tax-sheltered accounts.

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Corporates

Funds that invest in intermediate- and long-term investment-grade corporate bonds returned 1.5% and 2.0%, respectively, during the first quarter, according to Morningstar. Junk bond funds posted an average return of more than 5% for the second quarter running.

Corporate funds, especially those holding longer-term bonds and junk issues, attracted the attention of income-hungry investors discouraged by shrinking money market yields.

Grannis of Western Asset Management thinks those investors were on to something. He believes the low-inflation environment, with interest rates pushed to the floor by the Federal Reserve, is likely to spur productivity and produce noticeable if still moderate economic growth -- and corporate earnings that may surprise some investors and ensure that companies keep current on their bond payments.

Lipper senior analyst Andrew Clark said that for cautious investors, funds that invest in Treasuries remain a good bet for the near future. But investors willing to shoulder some extra risk could do much better in corporate bond funds, especially those investing in high-yield issues, he said.

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International

International bond funds recorded their fourth straight quarter of gains -- a marked change after falling in eight of the 10 previous quarters. The funds were helped by a stronger euro, which boosted their returns when translated into dollars.

In addition, Lipper analysts noted, there were modest bond rallies in several major countries, including Britain, where the Bank of England unexpectedly lowered interest rates, driving bond prices higher.

The clear winners of the quarter, however, were funds that invest in emerging-markets bonds -- such as those from Brazil, which soothed the fears of investors who had worried it would default on its debts.

Though yields remain high on emerging-markets debt, especially in comparison with those offered by the governments of developed nations, experts urge caution.

“Because they’ve done so well, I’m not a raging bull on ... emerging markets,” Pimco’s Gross said.

“It pays to be somewhat cautious because the prices are definitely higher and the yields lower than three months ago.”