Bonds Manage a Solid Performance

Bond mutual fund investors came through 2004 in much better shape than many had feared.

Every category of bond funds posted a positive total return for the year, meaning interest earnings plus or minus change in principal, according to Morningstar Inc. Most bond categories had annual total returns in the range of 2% to 9%.

The big surprise was that long-term interest rates fell for the year, even though the Federal Reserve began to raise short-term rates for the first time since 2000.

The benchmark 10-year Treasury note yield ended the year at 4.22%, down from 4.25% at the beginning of 2004.

The average yield on an index of corporate junk bonds tracked by KDP Investment Advisors ended last year at 6.43%, down from 7.17% a year earlier.

Long-term rates spiked in the spring, before the Fed began to tighten credit. But in the second half of the year the trend in long-term rates was mostly down.

Bond fund managers point to a number of factors that pulled rates lower. One was heavy buying of Treasury bonds by Asian central banks. Another was a bet by many investors that long-term bond yields remained attractive relative to inflation expectations.

Andrew Clark, an analyst at fund tracker Lipper Inc. in Denver, said long-term bond funds -- particularly corporate and foreign-bond portfolios -- still offer decent return potential relative to the risk they entail.

As the Fed continues to raise short-term rates, long-term rates are unlikely to decline this year, Clark said. But neither do they have to rise much, he said. The result may be that investors in long-term bonds will take home their interest earnings, without much change in principal value, Clark said.

The perennial risk is that inflation could rise faster than expected, analysts say. If that happens, the Fed could raise short-term rates at a much faster pace, driving long-term rates higher as well -- and devaluing older bonds that pay lower fixed rates.