A Risky Time for Bonds

Most bond mutual funds are having a tough time competing with plain old cash this year, amid rising interest rates and worries about inflation.

The interest returns, or yields, on bond funds are beating the 3.1% annualized yield that money market funds currently pay, on average.

But adjusted for losses of principal value -- caused when increases in market interest rates devalue older fixed-rate bonds -- the total return on the average government-bond fund was a negative 0.5% in the third quarter.

For the first nine months, government-bond fund returns averaged 1.5%, according to Morningstar Inc. Corporate-bond funds also averaged 1.5%.

That’s slightly less than the average money market fund, which generated a return of nearly 1.6% in the nine months. (Money funds generally don’t face risk of principal loss.)

With the recent surge in inflation concerns tied to energy prices, bond fund investors should be prepared for a rough ride in the fourth quarter, many experts warn.

The big unknowns facing bonds: How high will inflation, and inflation expectations, go in the near term? And how much higher will the Federal Reserve raise interest rates to slow the economy and combat inflation?

Immediately after Hurricane Katrina hit the Gulf Coast on Aug. 29, some economists confidently proclaimed that the Fed would at least temporarily halt its credit-tightening campaign.

They were wrong. The Fed on Sept. 20 raised its key short-term rate for the 11th time since mid-2004, to a four-year high of 3.75%. And since then, in numerous speeches Fed officials have been loud and clear about the need to keep boosting rates.

That helped drive yields on new Treasury bonds up sharply in September, sending prices of older bonds down. One result: The Pimco Total Return fund, the world’s largest bond fund, was sporting a year-to-date total return of 3.2% as of Aug. 31. That shrank to 2% as of Sept. 30. The fund lost 0.6% for the full quarter.

Now, there is substantial disagreement among Fed watchers about how high policymakers will go with short-term rates.

Allen Sinai, head of Decision Economics Inc. in New York, says the Fed’s key rate could be as high as 5% by mid-2006.

Money managers at Pimco in Newport Beach, however, believe the Fed is nearly done. They expect just one more increase, to 4%, because going higher would risk a recession, they say.

Perverse as it sounds, a weak economy is a bond investor’s good friend because it usually means longer-term interest rates will be falling, boosting the principal value of existing bonds.

Indeed, even if the Fed’s rate goes to 5%, longer-term yields could peak below that because investors often rush to lock in yields before the Fed rate peaks. The 10-year Treasury note yield, a benchmark for long-term rates, was 4.39% on Thursday.

But if inflation is worse than expected, there’s no telling how high investors could push bond yields. Inflation is the great enemy of bonds because it eats away at fixed-rate returns.

“We’re at the point in the business cycle where inflation is everything” in terms of investors’ concerns, Sinai said.

If inflation and interest rates continue to rise, most bond funds are likely to be money losers -- although even in their worst years, bond fund losses typically are in single digits.

In times of rising rates, funds that own longer-term bonds suffer more than those that own shorter-term bonds. That was true in the third quarter.

Tax-free municipal bond funds also have held up better this year than U.S. government or corporate bonds.

Kathleen Gaffney, co-manager of the Loomis Sayles Bond fund in Boston, says she continues to hold about 30% of its portfolio in high-yield bonds, including corporate issues and emerging-market bonds.

Despite the risks, Mexican and Brazilian bonds offer “double-digit yields, and inflation is coming down in those countries,” she said.