Bond Fund Returns Rise but May Face Pressures

The second quarter provided another dose of positive returns for many bond mutual fund investors, although rising long-term interest rates indicate that the recent era of heady performance for fixed-income funds may be coming to an end.

The average government bond fund notched a total return -- interest plus any price appreciation -- of 1.4% in the three-month period ended June 30, continuing the positive results that fixed-income investors have come to expect over the last three years. Corporate bond funds did even better, providing an average total return of 4.1% in the quarter, according to fund tracker Morningstar Inc.

But there were signs the tables are turning. Treasury bond yields that had fallen to lows not seen since the Eisenhower administration began to rebound in late June as investors bet on a global economic turnaround in the second half of the year.

A reviving economy probably would push long-term interest rates higher -- and that would spell bad news for many bond fund investors. When interest rates rise, the value of older bonds falls, dragging down the returns of fixed-income funds, especially those that hold longer-term securities.

“We’re going to have a recovery belch” if the economy reignites, said James W. Paulsen, chief investment strategist for Wells Capital Management in Minneapolis. The yield on the benchmark 10-year Treasury note, now at 3.65%, “could go to 4.25% in a heartbeat.”

Meanwhile, stocks, trounced by bonds for three years running, staged a full-tilt rally that propelled the Standard & Poor’s 500 index to a 15.4% total return for the second quarter. The sudden surge in the equity market was seen by some as a harbinger of better economic times.

As in the first three months of the year, the big winners in the second quarter were funds that invest in the bonds of emerging-market nations, as well as high-yield, or junk, bond funds, whose performance tends to track the stock market. Total returns averaged 11.1% for emerging-market bond funds during the quarter and 8.4% for high-yield funds, according to Morningstar.

For investors seeking tax-free income, California long-term municipal bond funds recorded an average total return of 2.4%. But the muni bond scene is complicated by the state’s unresolved $38-billion budget shortfall and the political uncertainty surrounding the effort to recall Gov. Gray Davis, which have resulted in a series of credit downgrades by bond rating firms.

Here’s a more detailed look at the second-quarter performance of major bond fund categories and where they may be heading:

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Treasuries

With corporate corruption, war and deflation talk in the news, investors had ample reason to seek safety in Treasury securities. And even though long-term interest rates were rising at quarter’s end, they still were lower than when the period began on April 1.

Funds that invest in intermediate-term government bonds -- securities that mature in fewer than 10 years but more than four -- are a favorite of conservative investors. On average, they notched total returns of 1.3% for the second quarter and an impressive 8.5% a year over the last three years.

But bond investors shouldn’t bet on seeing returns like that again for a while, said economist Donald Straszheim, noting that the yield on the 5-year Treasury note fell by more than half from April 2002 to June 2003. The president of Straszheim Global Advisors in Santa Monica believes investors have created a “Treasury bubble” akin to the stock bubble of the late ‘90s.

“It’s over,” Straszheim said of the Treasury rally.

Investors seemed to agree. Treasury funds experienced a small net outflow of cash in the second quarter, according to preliminary estimates from AMG Data Services of Arcata, Calif. -- the only bond category to see net outflows in the period.

Few bond experts, however, would advise the average investor to abandon Treasury securities entirely.

“They are the safest investment, and they should be part of any bond portfolio,” said Andrew Clark, a senior analyst with fund tracker Lipper Inc. But corporate bonds probably will prove the better investment over the next few months, he added.

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Corporates

Corporate bonds also can lose value if rates rise. But since their prices reflect a risk of default, they can be worth more if an improving economy, cost-cutting by management or higher productivity among workers boosts profits at the companies issuing the bonds.

Despite rising unemployment and a mixed bag of other economic news, belief that corporate fundamentals are improving contributed to a net inflow of $11.9 billion into funds that invest in investment-grade corporate bonds, according to AMG.

An additional $10.3 billion poured into junk-bond funds, which recovered powerfully from a tailspin late last year when “the market priced high-yield like every worst-case scenario was going to take place,” said Fred Hoff, manager of the Fidelity High-Income Fund, which was up 9.7% for the quarter.

As fears of catastrophe diminished, many companies were able to reduce their financial stress by refinancing debt at lower rates, Hoff said. He predicted that high-yield bonds would continue to outperform other bonds this year.

“The market is pretty much fully cleansed of all the new-economy tech and telecom start-ups that never should have been financed” in the first place, he said.

Lipper’s Clark cautioned, however, that investors currently lured by the higher yields on corporate bonds could turn against the securities if the hopes for a better economy don’t bear fruit by the fourth quarter.

“Seeing some good data on corporate earnings, capital spending, employment and the gross domestic product will be key for sustainability,” he said.

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Munis

Despite budget woes in California and other states, many analysts remain bullish on municipal bonds, a standout in many investment portfolios since 1999.

For the last six months, top-rated tax-free municipals have had about the same yields as taxable Treasury securities of equivalent maturities, “and after adjusting for the tax benefit, it’s like picking up another 2 or 3 percentage points of return for most investors,” Clark said.

The average total return on long-term municipal bond funds nationwide was 2.7% during the second quarter, according to Morningstar, and investors willing to take on extra risk with high-yield muni funds were rewarded with a total return of 3.5%. For those who believe the economy is recovering, the high-yield muni funds look attractive, Paulsen said.

Still, budget woes may have weighed down California muni funds, which on average lagged behind muni funds of other states.

Robert Pariseau, who manages the USAA California municipal bond fund, said he expects longer-term interest rates to rise further, which will cut into future bond returns. But munis typically hold their value better than other fixed-income investments during such periods, he said, advising long-term investors who won’t need their principal for two or three years to hang on to their munis and “ride the cycle out.”

For those just getting into municipal bonds, he advises going slow by making purchases gradually from now until the first quarter of 2004 -- good advice for any new bond investments in a time of rising rates.

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Foreign bonds

International bond funds returned 6.3% on average during the quarter, in part because the falling value of the dollar against other currencies made foreign investments worth more. The greenback in recent weeks has rebounded off its lows against the euro and the yen, however.

International bonds could see some benefit if the European Central Bank cuts interest rates again, Clark said, “but for all practical purposes, European and Japanese rates have probably bottomed.”

Much of the double-digit surge in emerging-market bond funds resulted from Brazil’s success in reforming its tax and social security systems, Clark said. The funds also benefited from a strong performance by Mexico’s bonds, which closely track the American bond market.