The typical money market mutual fund generated a higher return in 2005 than most bond funds, and this year is shaping up to be a tough test for bonds as well.
The basic problem for bond funds is that short-term interest rates are at their highest levels in nearly five years, and are close to -- and in some cases above -- what long-term bonds pay.
That's making it harder for investors to justify the risks in owning bond funds.
In 2005, the average government bond fund produced a total return of 1.9%, according to Morningstar Inc. The average corporate fund's total return was 2%. Total return is interest income plus or minus a fund's net change in principal value.
Both the government and corporate fund averages trailed the 2.7% yield earned by the average money market fund for the year, according to IMoneyNet Inc.
Many bond funds paid higher interest income for the year than did money funds, but rising market interest rates depressed the value of older, lower-yielding bonds in fund portfolios. That eroded the principal values of many bond funds.
There were exceptions. Emerging-market bond funds had another good year, producing an average total return of 11.7%. Besides paying high yields, the funds got a boost as the dollar fell in value against currencies of some major emerging-market bond issuers, including Brazil and Mexico.
But for an investor contemplating whether to hold or buy a bond fund today, a few numbers show why many bond sectors are a difficult sell:
The current annualized yield on the Vanguard Intermediate-Term Treasury fund, a popular low-cost fund, is about 4.32%. By contrast, an investor could earn an annualized 4.40% on six-month Treasury bills bought directly from Uncle Sam. And the current yield on the average money market fund is 3.6%, and rising.
Short-term interest rates have surged since mid-2004 as the Federal Reserve has raised its benchmark rate from 1% to 4.25%. But the Fed has been signaling over the last month that it is probably near the end of its credit-tightening campaign.
If the Fed is nearly done, there are two possible scenarios for interest rates:
* The Fed holds short-term rates near current levels for an extended period, perhaps all of 2006. If that's the case, money market funds and other shorter-term cash accounts could continue to provide stiff competition for many bond funds.
Tad Rivelle, chief investment officer at Metropolitan West Asset Management in Los Angeles, expects that the economy will continue to grow this year and that bonds will produce "reasonable but unspectacular returns."
* The Fed begins cutting short-term rates, either in the spring or in the second half of the year. Under this scenario, yields on long-term Treasury bonds and other high-quality issues could fall as well. Bond funds that own those kinds of securities could do well because they would have locked in higher yields.
But for the Fed to start easing credit, the assumption is that policymakers would be responding to a softening economy. That could mean trouble for corporate junk bond funds.
Junk bonds are those rated below investment grade. They pay above-average yields because the companies that issue them are relatively risky; they may have heavy debt loads or are in businesses vulnerable to downturns in a weaker economy.
The junk market got a scare last spring, as Wall Street began to focus on the possibility that General Motors Corp. could file for bankruptcy protection because of its financial woes. Some investors dumped junk bonds, driving their prices down; in turn, investors demanded higher yields on newly issued junk bonds to compensate for what they perceived as a rising risk of defaults.
The result: The average total return on junk funds was a disappointing 2.5% last year, as declining principal values offset most of the interest earned.
Paul McCulley, an economist and portfolio manager at bond fund giant Pacific Investment Management Co., or Pimco, in Newport Beach, is in the camp that believes that the economy will slow this year. That makes Pimco cautious about corporate bonds, particularly junk issues, he said.
"The clearest risk is the potential for a rising default rate in the high-yield bond arena," McCulley said.
For investors who need the income that bonds generate, and who can weather swings in principal value, two perennial bits of advice may be especially useful this year:
* Consider municipal bond funds. Muni bond funds held up relatively well in 2005 compared with other bond sectors. The average long-term California muni fund produced a total return of 3.8%, according to Morningstar.
Because California residents don't pay federal or state income tax on California muni interest, the true return on the funds was higher than the stated figure, depending on an investor's tax bracket.
Bond investors should look at their tax brackets and calculate whether they could earn a better rate of return on munis than on corporate or Treasury funds.
* Pay attention to bond fund management fees. If longer-term interest rates stay relatively low in the next few years, bond funds will have a hard time generating high returns even in otherwise good environments. This means that the difference between above-average and below-average returns may be the amount a fund takes in annual management fees.
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Bond fund performance by Morningstar category
Here are average total returns for bond mutual fund categories tracked by Morningstar. Total return is dividend or interest income plus or minus any principal change. All data are through Dec. 30. Figures for periods longer than one year are annualized averages. For category descriptions and the best-performing funds in each category, see tables on Pages C14-15.
*--* Objective Total return Ann 12-mo. ual ize d tot al ret urn Category category 4th-q. 2005 3-y 5-yr. yield r. Emerging markets EB 1.5% 11.7% 17. 15.9% 6.0% 6% High-yield muni HM 1.2 6.2 6.5 6.2 4.6 Bank loan BL 1.1 4.5 6.7 4.7 4.5 Muni California MC 0.7 3.8 4.1 4.8 3.9 long-term* Long-term government GL 0.2 3.4 5.1 6.7 4.3 Muni long-term ML 0.6 3.0 3.9 4.8 3.7 (national)* Muni single state SL 0.6 2.8 3.7 4.7 3.7 long-term* Ultra-short-term UB 0.7 2.5 1.8 2.7 3.0 High-yield (junk) HY 0.9 2.5 12.0 7.2 6.9 Long-term investment CL 0.3 2.2 6.1 7.2 4.8 grade Multi-sector MU 0.4 2.0 9.2 7.7 5.2 Intermediate-term GI 0.4 1.9 2.4 4.6 3.7 government Muni California MF 0.4 1.8 2.5 3.8 3.2 intermediate-/short-t erm* Intermediate-term CI 0.4 1.8 3.6 5.3 3.9 investment grade Muni MI 0.5 1.8 2.9 4.4 3.4 intermediate-term (national)* Short-term investment CS 0.5 1.4 2.0 3.8 3.2 grade Short-term government GS 0.4 1.2 1.3 3.6 3.3 Muni short-term MS 0.4 1.2 1.6 2.9 2.4 (national)* Muni single state SS 0.4 0.8 1.9 3.3 2.9 short-term* World IB -1.0 -3.2 6.2 6.6 4.8 Government bond fund 0.4 1.9 2.4 4.5 3.7 avg. Corporate bond fund 0.5 2.0 5.6 5.6 4.5 avg. International bond -0.4 0.6 9.2 9.1 5.1 fund avg.
*Because interest on municipal bonds is tax-exempt, real returns will be higher than stated returns and will depend on an investor's tax bracket.
Source: Morningstar Inc.
Mutual fund expense ratios
Mutual fund expenses for operations and management fees are reported as an "expense ratio," the percentage of fund assets taken annually by the fund company. Certain kinds of funds are more expensive to run than others, so investors should compare their funds' expenses with the category averages, shown below.
*--* Avg. expense Avg. expense Category ratio Category ratio Pacific/Asia 2.1% Mid-cap growth 1.6% ex-Japan Diversified 2.0 Small-cap value 1.6 emerging mkts. Bear market 2.0 Natural resources 1.6 Latin America 1.9 Real estate 1.6 Foreign 1.9 Utilities 1.5 small-/mid-cap grow Technology 1.9 Small-cap blend 1.5 Health 1.8 Large-cap growth 1.5 Diversified 1.8 Foreign large-cap 1.5 Pacific/Asia value Foreign large-cap 1.8 Convertibles 1.5 growth Europe 1.8 Mid-cap value 1.5 Financial 1.8 Mid-cap blend 1.4 World 1.7 Large-cap value 1.4 Foreign 1.7 World allocation 1.3 small-/mid-cap value Small-cap growth 1.7 Moderate allocation 1.2 Communications 1.7 Large-cap blend 1.2 Precious metals 1.7 Conservative 1.2 allocation Japan 1.6 Domestic stock fund 1.4 avg. Foreign large-cap 1.6 International stock 1.7 blend fund avg.
*--* Avg. expense Avg. expense Category ratio Category ratio Emerging markets 1.5% Interm.-term invest. 1.1% grade Bank loan 1.4 Long-term invest. 1.0 grade Multi-sector 1.3 Short-term invest. 1.0 grade High-yield (junk) 1.3 Short-term government 1.0 World 1.3 Muni interm.-term 1.0 (national) High-yield muni 1.2 Muni California 0.9 interm./short Muni single state 1.2 Muni short-term 0.9 long-term (national) Muni long-term 1.1 Ultra-short-term 0.8 (national) Muni California 1.1 Government bond fund 1.1 long-term avg. Long-term government 1.1 Corporate bond fund 1.1 avg. Interm.-term 1.1 International bond 1.3 government fund avg. Muni single state 1.1 short-term
Source: Morningstar Inc.