Bonds Help Hold the Line

Bond mutual funds aren’t making anyone rich this year, but they’re helping some investors avoid getting poorer.

All but one category of bond fund produced a positive total return in the second quarter and in the first half, according to Morningstar Inc.

By comparison, the average domestic stock mutual fund slipped 0.3% in the half.

The average government bond fund had a total return of 2.4% in the quarter and 2% in the half; the average corporate bond fund earned 2.1% and 1.4%, respectively.

Total return on a bond fund is interest earned plus or minus the change in the fund’s principal value.

The big surprise for many bond investors this year was that long-term interest rates ended the first half below their levels of a year earlier -- even though the Federal Reserve raised its benchmark short-term rate nine times over that span, from 1% to 3.25%.

The annualized yield on a 10-year Treasury note, for example, declined from 4.58% on June 30, 2004, to 3.91% by the end of last month, although it wasn’t a straight line down.

Falling long-term yields boosted the principal value of older long-term bonds that had been issued at higher fixed rates, thereby lifting many bond funds’ total returns.

Why long-term rates haven’t followed short-term rates has baffled many bond-market pros. Some say investors worldwide have been eager to lock in long-term-bond yields, putting downward pressure on them, because of expectations that the global economy will slow sharply over the next year.

Greg Habeeb, manager of the Calvert Income bond fund in Bethesda, Md., says it’s possible that the downward trend in long-term rates will continue. “But I would not bet the moon on that,” he said.

So he figures the smartest strategy with his $3.5-billion portfolio is to be relatively conservative, and to be prepared to buy bonds at higher yields later this year or in 2006, he said.

If long-term rates rise sharply, however, bond fund total returns could turn negative in the near term as falling principal values offset interest earnings. That nearly happened with funds that own so-called junk, or below-investment-grade bonds, in the first half.

The average junk fund was barely positive in the period, earning a total return of 0.3%, according to Morningstar. Fear of financial problems at General Motors Corp. in spring helped trigger a sell-off in many corporate junk issues, driving yields higher.

The result was that the yield on an index of 100 junk bonds tracked by KDP Investment Advisors ended the half at 7.24%, up from 6.43% at the start of the year. That depressed junk funds’ principal values.

Raymond Kennedy, manager of the $6.7-billion Pimco High Yield fund in Newport Beach, noted that the junk market had calmed since the GM scare. The KDP index yield has fallen from a peak of 8.1% in mid-May.

If the economy stays on a decent growth track, “I think we’re in a relatively benign environment in the near term” for junk bonds, Kennedy said.

But he said an increasingly pressing issue for all investors is whether it’s worth taking the risk in bonds compared with shoveling more money into shorter-term securities, such as Treasury bills, as those rates rise.

Investors now can earn a 3.4% annualized yield on a six-month T-bill. By contrast, a five-year Treasury note pays about 3.8%.

“It becomes a little more difficult for investors to jump into bonds” as short-term rates offer greater competition, Kennedy said.

One sector that still deserves a look, some analysts say, is municipal bonds. Funds that own long-term California muni issues had an average total return of 3.1% in the first half.

Because muni interest is exempt from federal (and often state) income tax, the real return on the bonds is higher, depending on an investor’s tax bracket.

Rising real estate values are improving the finances of many states and cities, in turn boosting investors’ confidence in the underlying credit quality of muni bonds, analysts say.