After 3 Years of Losses, Stock Funds' Biggest Challenge May Lie Ahead

Times Staff Writer

Burned yet again by stocks, mutual fund investors who turned to the relative safety of the bond market in 2002 were rewarded with strong gains.

It was the third straight year in which debt securities outshone stocks -- the first time that's happened since 1939-41. Adding interest payments to bond price appreciation, the 2002 "total return" was 10.2% for a broad bond index tracked by Lehman Bros.

The benchmark Standard & Poor's 500-stock index, meanwhile, suffered a negative total return of 22.1%.

Last year's gain for the Lehman bond index followed returns of 8.4% in 2001 and 11.6% in 2000. During that time, the S&P; 500 plunged 40.1%.

But not all was perfect in the fixed-income universe last year, and some experts are seeing signs that the long bull run for bonds may be coming to an end.

The gains have mainly resulted from the Federal Reserve's two-year campaign to ratchet down short-term interest rates; bond prices move up as yields decline.

The Fed's latest cut, in November, sliced its target short-term rate -- already at a 40-year low -- by half a percentage point to 1.25%.

The 10-year Treasury note, a benchmark security that began the year yielding 5.03%, ended it at 3.82%. It was a level many analysts say can't be sustained this year -- a view that gained support last week when bond yields rose dramatically after an unexpectedly robust report on U.S. manufacturing. By Friday the 10-year T-note was at 4.02%.

"We've been spoiled for the past three years" by declining Fed rates, said Mark Kiesel, a senior portfolio manager at the Pimco funds in Newport Beach, the nation's largest group of bond mutual funds.

Kiesel figures about 6 percentage points of last year's average bond fund returns were due to the effect of falling interest rates on bond prices. "But," he warns, "now the bull market's over."

With that possibility in mind, analysts are especially cautious about longer-term bonds, whose prices could plunge the most if rates rise again.

"Long-term Treasury yields have probably already reached their low for this cycle," said James Paulsen, chief investment officer at Wells Capital Management. In his New Year's message last week, Paulsen advised investors to focus on beaten-down stocks and shorter-term bonds.

Here's a more detailed look at the performance of the various bond mutual fund sectors last year and the outlook for 2003.

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Treasuries

Reacting to the sluggish economy, corporate scandals and threats of war, investors seeking safety flocked to U.S. government securities. Funds holding long-term Treasuries rose an eye-popping 13.2% for the year, on average, according to Morningstar Inc.

In a year in which yields on money-market funds fell below 1%, even short-term U.S. government funds were able to notch an average total return of 6.6%, according to Morningstar.

But after the big run-up last year in demand and prices, the consensus among analysts is "anything but Treasuries," said Eric Jacobson, a senior bond analyst at Morningstar.

Assuming the economy continues to recover, "The real question isn't if rates will rise, but when, and by how much and for how long," he said.

Rising market interest rates would pummel the prices of Treasury securities -- and the mutual funds that invest in them. Indeed, as rates gyrated in the fourth quarter, returns in most categories of fixed-income funds slowed drastically. For instance, long-term Treasury funds returned a meager 0.6% in the fourth quarter.

Investment pros who still favor Treasury securities say market rates could go even lower if the economy stumbles again. Also, those with the most dire economic outlook -- an expectation that the global economy is headed for a serious deflationary period -- view Treasuries as the safest asset to hold under those circumstances.

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Municipals

The total return on funds that invest in long-term tax-free municipal debt nationwide averaged 8% in 2002, according to Morningstar. Funds that focus on long-term California muni bonds also had an average total return of 8%, the interest portion of which was tax-free.

Given that state and federal taxes consume 44% of the earnings of Californians in the highest tax bracket, those are "fantastic" returns, Kiesel said.

A tax-free muni yield of 4.2% is equal to a fully taxable yield of 7.5% for someone in the highest state and federal marginal bracket in California.

Although he doesn't expect muni funds' hefty returns of 2002 to continue this year, Kiesel said Pimco still regards munis as good buys compared with Treasury securities.

U.S. Trust Senior Vice President Gary Larsen, who manages the Excelsior California Tax Exempt Income Fund, which notched a 4.7% total return last year, said muni bonds now are paying 80% to 90% of the pre-tax yield of comparable Treasury securities, which are subject to federal (though not state) taxes. Historically, that is a generous yield level for muni issues relative to Treasuries.

But Larsen advises clients not to chase the longest-term municipal bonds and muni funds because of the danger that would be posed by rising rates.

"I'd rather be in a five-year at 2.25% right now than in a 30-year at 5%," he said, "because the 30-year muni could be worth 50 or 60 cents on the dollar very quickly" if the economy takes off and interest rates rise.

"We don't expect that much of a move, but we've seen markets where that's taken place."

Due to California's $35-billion budget deficit and faltering credit rating, many wealthy clients of U.S. Trust recently have been looking to limit purchases of state-issued debt, Larsen said. Instead, they are looking at bonds from other municipal issuers in California, and in some cases from outside the state.

A word of caution: The place for muni bonds and the funds holding them is in taxable accounts, not retirement accounts in which earnings already grow tax-free or tax-deferred.

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Corporates

Despite meltdowns in energy and telecom company bonds, there was money to be made in higher grade corporate debt last year. Funds investing in long-term investment grade corporate bonds recorded an average total return of 8.6% in 2002, according to Morningstar.

Investors already seem to have decided that the sell-off in "junk" bonds -- those rated below investment grade -- was overdone. Though the category was in negative territory for the year -- the average total return was a negative 2.1% -- high-yield funds rose by 5.9% in the fourth quarter.

Jacobson said funds holding corporate bonds won't be hurt as much as those invested in Treasuries if a strengthening economy pushes rates higher, because a stronger economy also should make defaults by corporate issuers less likely.

Corporate bonds at the lower end of the investment-grade ratings -- a Pimco favorite -- and in the junk category presumably would benefit the most from economic strength. A rise in a company's profit could push credit ratings higher, which in turn would boost the price of bonds.

When the economy took off in 1994 and the Fed raised rates sharply to hold down inflation, high-yield bonds held their value better than investment-grade bonds, Jacobson said.

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Foreign

Whether U.S. investors should dabble in foreign bond funds is a matter of debate among analysts, because foreign funds' performance involves such complex factors as relative changes in interest rates among countries and fluctuations in exchange rates.

Still, there is no doubt that the often volatile funds can present opportunities.

At Pimco, Kiesel's top choice among all bond investments is German government securities -- a bet that interest rates in that country will decline as a result of a sluggish economy, while the euro will remain strong.

In any case, international bond funds turned in an impressive performance last year, with a total return averaging 13.6%, according to Morningstar.

And the relative handful of funds that focus on emerging-markets countries' debt rocketed 13.3% in the fourth quarter -- a result, Kiesel said, of investors deciding to return to more speculative investments, a trend reflected in recent surges in the prices of stocks and junk bonds.

For The Record Los Angeles Times Wednesday January 08, 2003 Home Edition Main News Part A Page 2 ..CF: Y 11 inches; 420 words Type of Material: Correction Mutual fund returns -- Articles on mutual funds in Monday's Business section contained some erroneous fund returns provided by Morningstar Inc. An article on bond funds said the 2002 return for the Excelsior California Tax Exempt Income Fund was 4.7%. Its return last year was 6.5%. An article on stock mutual funds said 2002 returns for the Evergreen Precious Metals Fund and the Prudent Bear Fund were 38.4% and 50.6%, respectively. The returns for those funds were 72.4% and 62.9%, respectively. Corrected tables showing all fund returns appear on C12-15.
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