Summer Rebound in Yields Takes Toll on Bond Funds

For many bond mutual fund investors, the best that can be said about the third quarter is that it could have been worse.

It almost was: The summer’s dramatic rebound in yields on high-quality bonds began to reverse in September, reducing the red ink that many funds had begun to pile up in the quarter as older fixed-rate bonds sank in value.

But by late last week, bond yields were soaring anew after the government said the economy posted a net gain in jobs last month, the first in eight months.

Some Wall Street pros say that investors in Treasury issues and other high-quality bonds should get used to disappointment. If the economy is on a sustained growth track, they say, then it’s more logical to assume that interest rates will be higher a year from now, not lower.

“The underlying direction of interest rates is pointing up,” warned Lou Crandall, an economist at Wrightson ICAP, a New York-based economic research firm.

That’s generally bad for bond owners, of course, because as new bonds offer higher yields to entice investors, existing securities paying lower yields become devalued.

Still, investment performance is all relative: A lousy time for bond investors might mean single-digit annual percentage losses -- a far cry from what many stock investors lost from 2000 through 2002.

And what’s bad for some bonds, such as Treasuries, can be good for others, such as high-yield corporate “junk” securities.

Here’s a look at how key bond mutual fund sectors performed in the third quarter and first nine months, and the outlook:

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Government Bonds

The whiplash in Treasury bond yields from mid-June to early September lifted the benchmark 10-year T-note yield from a generational low of 3.11% on June 13 to 4.6% by Sept. 2. It was one of the wildest reversals in U.S. bond market history.

Investors dumped Treasuries as economic data pointed to continued strength in consumer spending and a recovery in the battered manufacturing sector.

But the rebound also was a function of the massive speculation that had driven Treasury yields so low by mid-June, experts say. Hedge funds and other big investors had piled into Treasuries in May and early June, in part betting that the Federal Reserve would begin to buy government bonds in the open market to push yields even lower.

That view was fueled by Fed officials’ warnings in May that the economy faced some risk of falling into a deflationary spiral, meaning a period of broad and sustained price declines.

But as the economic data improved, deflation fears ebbed -- and it became clear that the Fed wasn’t about to buy bonds. So the great bond sell-off began.

By September, however, some investors were again betting on a weakening economy. Heavy buying of Treasury bonds drove the 10-year T-note yield down to 3.94% by early last week.

With the September employment report on Friday, bond bulls were routed anew. The 10-year T-note soared to 4.20%.

For the third quarter, the average long-term government bond fund posted a “total return” -- interest earnings plus or minus principal change -- of negative 2.5%, according to fund tracker Morningstar Inc.

Intermediate-term government bond funds had an average total return of negative 0.3%, demonstrating that the harmful effects of rising interest rates are less severe as a bond is closer to its stated maturity date.

Still, investors who have any faith in an economic rebound should be wary of government bonds, many analysts say.

Though yields have risen since mid-June, “I don’t know why they’re still as low as they are,” said Tom McManus, an investment strategist at Banc of America Securities in New York.

It’s true that the Fed has pledged to hold its key short-term rate at the current 1% well into 2004, to help the economy. But as the summer has shown, longer-term interest rates are controlled by the marketplace. Investors are likely to push yields higher long before the Fed finally begins to tighten credit, McManus and others warn.

An added risk: The weakening dollar could make foreign investors less willing to buy, or hold, U.S. bonds. That could put additional upward pressure on yields, especially given the Treasury’s borrowing needs, with the federal deficit at record levels.

What the bond market doesn’t yet know is, “Where is the pain threshold for foreign buyers?” in terms of the dollar’s level, said Jay Bryson, global economist at Wachovia Corp. in Charlotte, N.C.

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Corporate Bonds

All of the warnings that apply to government bonds also apply to high-quality corporate issues, though to a lesser extent, experts say.

In the third quarter, rising yields on high-quality corporate bonds left the average long-term investment-grade bond fund with a total return of negative 0.5%, according to Morningstar.

But corporate issues have two advantages over government bonds in a rising-rate environment, analysts note: One is that the yields on corporate issues are higher to begin with; the other is that improving fortunes of companies can help support the prices of their bonds.

And for one large subsector of the corporate market -- junk issues, meaning those rated below investment grade -- an improving economy can far outweigh the effects of rising interest rates.

In the third quarter the average junk bond fund posted a positive total return of 2.7%. In the first nine months the sector’s average return was a positive 17.4%, as falling junk yields boosted the value of older bonds.

Even as Treasury bond yields were soaring late last week, the average yield on an index of 100 junk bonds tracked by KDP Investment Advisors fell to a five-year low of 8.24%.

But can junk keep its momentum going?

Margaret Patel, high-yield fund manager at Pioneer Investment Management in Boston, said she expects the junk market to stay healthy into 2004, thanks to yield-hungry investors, a declining default rate among junk issuers and a rising stock market that can provide junk issuers with more access to fresh capital, bolstering their finances.

But she thinks it’s smarter to stick with better-quality junk than the lowest-quality (and highest-yielding) issues.

“The market is pretty picked over,” Patel said. “It’s a relative-value game now.”

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Municipal Bonds

California muni bond prices were dragged down in the third quarter by the general rise in market rates and by the state’s specific woes -- meaning the budget problems and the recall election.

The average long-term California muni bond fund lost 0.6% in the quarter on a total-return basis, as price declines more than offset interest earnings.

But California muni yields have fallen sharply since early August. A Bloomberg News yield index of 20-year California general-obligation bonds peaked at 5.46% on Aug. 4, and was at 5.14% by the end of last week.

“The overall consensus in the muni market is that the worst is behind us” for California bonds, said Steven Permut, a muni fund manager at American Century funds in Mountain View, Calif.

The state budget plan “is smoke and mirrors, but at least there’s a plan,” he said. And the recall election will be resolved, one way or another, this week.

What’s more, the California muni market is being supported by heavy demand from individual investors, Permut said.

That makes sense given the returns afforded, he said: At 5.14%, a tax-free municipal bond yield provides a California investor in the combined 34% state and federal marginal tax bracket with a return equal to about 7.75% on a fully taxable bond.

So even if yields on new California muni issues rise over the next year, investors who plan to hold their bonds until they mature can lock in a decent return at current yields, and know they’ll get their money back at maturity -- barring a meltdown of the state’s economy.

The problem for muni bond mutual funds, as for all bond funds, is that they must price their shares every day to reflect moves in market interest rates.

Buy-and-hold investors in individual securities don’t face that constant reminder -- though if they had to sell their bonds before maturity, they would suffer if market yields had risen.

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Foreign Bonds

Few U.S. investors own foreign bonds. That might change if the dollar continues to weaken.

A falling dollar means foreign securities are worth more when translated into dollars. So the dollar’s slide this year has helped bolster foreign bond funds’ performance.

And in the case of emerging-markets debt funds, the gains in 2003 also reflect rising optimism about those economies, analysts say.