Riskier bonds keep allure
Risk-takers again were rewarded in the bond market in the first three months of the year, despite some mid-quarter jitters about the economy.
The on-again, off-again economic worries also served as a reminder to investors who’ve been sitting comfortably in money market mutual funds: If the Federal Reserve starts cutting short-term interest rates, your yields will drop -- and other fixed-income investments may look more attractive.
For now, however, Fed rate cuts appear unlikely anytime soon: The government said Friday that the economy created a net 180,000 jobs in March, far exceeding expectations.
That may keep investors upbeat about the economy, and keep their appetite strong for corporate junk bonds and other dicey securities.
Demand for those issues pushed up their prices in the three months that ended March 30. The result was that high-risk bonds generally produced better returns than lower-risk issues in the period:
* The average high-yield “junk” bond fund had a total return of 2.6% in the quarter, according to Morningstar Inc. Total return is interest earnings plus or minus any principal change.
* Funds that own bonds of emerging-market countries such as Brazil and the Philippines gained 2.2% in the quarter, on average.
* Bank loan funds, which invest in syndicated bank loans often used to finance corporate buyouts, were up 2%.
By contrast, lower-risk types of bond funds posted smaller returns. Funds that own long-term investment-grade securities, such as U.S. Treasuries and high-quality corporate bonds, gained 1.2% in the period, on average.
Although low-single-digit bond fund returns may not look like much, they beat the 0.6% total return of the blue-chip Standard & Poor’s 500 stock index in the quarter. And they topped the average money market mutual fund return of about 1.1%.
Rising U.S. mortgage delinquencies and a surge in lender failures shook up global financial markets in late February and early March, stoking fear that the stumbling housing market could drag the American economy into recession.
Some investors’ reaction was to dump bonds that might be hurt by a weak economy -- for example, junk securities, which are issued by companies that often have high debt levels and thus are vulnerable to financial trouble if their business slumps.
But the sell-off didn’t last long, and it wasn’t very deep.
The share price of the Pimco High Yield fund, a $7.4-billion-asset junk bond fund, dropped from $10 on Feb. 26 to $9.91 on March 5, a decline of less than 1%. By the end of the quarter it had edged back up to $9.94.
When bond prices drop the yields on the securities rise. The yield on an index of 100 junk bonds tracked by KDP Investment Advisors rose from a 20-month low of 7.02% on Feb. 26 to 7.26% on March 5. It was at 7.28% late last week.
That modest blip up in junk yields didn’t fix what many analysts believe is the basic problem with buying those issues now: “The riskier sectors of the bond market just aren’t offering much return for the risk,” says Scott Berry, a mutual fund analyst at Morningstar.
That has been Wall Street’s consensus view of high-risk bonds for the last year or so. But it hasn’t stopped investors from piling in.
Some fund managers say it’s still no contest between a junk bond yielding 7.28% and a 10-year U.S. Treasury note yielding 4.75%, the rate as of Friday.
Jill Fields, manager of the MassMutual Premier High Yield fund in Boston, said that although many investors would prefer better yields on junk issues, they’re mostly comfortable that the companies can handle their debt loads, and so continue to be drawn to the bonds.
In the junk universe, “there are a lot of companies that are doing really well” financially, Fields said. For example, she has made money on bonds of retailer Neiman Marcus Group and theater owner AMC Entertainment Inc. over the last year, she said.
Fields’ fund was up 2.9% in the quarter.
Still, she said the recent jump in mortgage delinquencies raised legitimate concerns about the outlook for consumer spending. “I’m getting a little more cautious on that front,” Fields said of the consumer.
Some analysts had been convinced that the economy was weak enough to compel the Fed to soon begin cutting short-term rates, for the first time since 2003.
But rate-cut hopes dimmed with the strong March employment report on Friday. Economists at Goldman Sachs & Co. had predicted that the Fed would start paring its key rate, now 5.25%, in June. Now, Goldman says the cuts won’t begin until September.
And then what? Historically, falling short-term interest rates also have pulled down long-term rates, such as on 10-year T-notes. Falling market rates make older bonds issued at higher fixed yields more valuable.
But because longer-term Treasury bond yields already have fallen since mid-2006, some analysts say they might not decline much more even if the Fed cuts short rates. That means the potential capital gain on long-term government bonds may be limited.
Morningstar’s Berry recommends that investors who have cash parked in money market funds be prepared to switch to a short-term bond fund if the Fed begins to signal rate cuts.
Money market fund yields tend to track the Fed’s moves, up or down, because the funds own very-short-term corporate and government IOUs.
The annualized compound yield of the average taxable money fund now is 4.88%, according to ImoneyNet.com.
“But when interest rates do come down, you’re going to be losing yield” on money funds, Berry said.
At that point, switching to a short-term bond fund -- a portfolio that focuses on securities maturing within a few years -- would give you a decent yield and also the chance for a modest principal gain, he said.
If you don’t believe that the Fed will be cutting anytime soon, and you’re more worried about inflation than about economic weakness, consider inflation-protected bonds or funds that own them. The bonds are designed to pay a return that rises with inflation.
Inflation-protected funds invest primarily in the Treasury’s version of those bonds. The funds rose 2.2%, on average, in the first quarter, as the bonds’ prices rose -- a sign that some investors were fearful about inflation pressures in the economy. Fed officials have continued to warn that inflation is running too high for their comfort.
Over the last five years inflation-protected bond funds have gained 6.7% a year, on average, according to Morningstar. That beat the 4.1% annualized total return of the average government bond fund.
*
(BEGIN TEXT OF INFOBOX)
Performance of biggest stock and bond mutual funds
Here are the biggest funds, by assets, ranked by their first-quarter
performance (measured by price change plus interest or
dividends). Funds with a foreign focus set the pace once again. The
Dodge & Cox International Stock fund, 2006’s best-performing big
fund, stayed on top in the first quarter. Recent holdings include
Matsushita Electric Inc., News Corp. and Credit Suisse Group.
Vanguard’s Total International Stock Index fund was ranked No.
2. The fund invests in three other Vanguard funds: the European
Stock Index fund, the Pacific Stock Index fund and the Emerging
Markets Stock Index fund. Category descriptions appear in the
tables on C11-12.
*--* Obj. Ovrl. 3-yr. Total return Fund cat. rtg. star 1st-q. 12-mo. 3-yr.* Dodge & Cox: Intl Stock FV 4 5 5.0% 22.3% 24.5% Vanguard: Total Intl FB 4 4 3.8 20.1 20.6 Stock Franklin: Income A CA 5 5 3.3 17.8 11.4 Fidelity: Balanced MA 5 5 3.1 10.2 11.0 Fidelity: Diversified FG 4 3 3.1 15.2 18.4 Intl American: EuroPacific A FB 4 2 2.9 16.6 19.4 American: Capital IH 4 3 2.6 19.4 14.6 Income Buildr. A Fidelity: Low-Priced MB 5 4 2.6 11.2 14.9 Stock American: Fundamental LB 5 5 2.5 13.8 15.2 Inv. A American: Capital World WS 5 4 2.4 18.1 18.2 G&I; A American: Income Fund MA 4 4 2.1 17.1 12.1 of Amer. A Fidelity: Magellan LG 3 3 2.0 3.2 7.2 American: New WS 3 2 1.7 15.3 14.5 Perspective A Dodge & Cox: Stock LV 5 4 1.7 14.5 14.4 Pimco: Total Return CI 5 4 1.7 6.3 3.7 Institl Vanguard: Windsor II LV 4 4 1.7 16.1 13.3 Dodge & Cox: Balanced MA 5 5 1.6 11.7 10.3 American: Growth Fund LG 5 4 1.4 7.8 11.6 Amer. A Vanguard: Total Stock LB 4 4 1.3 11.1 10.8 Market Idx. Vanguard: Total Bond CI 4 3 1.3 6.5 3.2 Index Fidelity: Puritan MA 4 4 1.3 12.4 9.2 Vanguard: Wellington MA 5 5 1.1 12.9 10.6 American: Invest. Co. LV 3 2 1.1 12.5 10.6 of Amer. A American: Washington LV 2 1 0.9 14.1 10.1 Mutual A American: Balanced A MA 3 2 0.8 9.6 7.3 Templeton: Growth A WS 3 2 0.7 16.2 14.6 Vanguard: 500 Index LB 3 3 0.6 11.7 9.9 Vanguard: Primecap LB 4 4 0.1 5.3 11.1 Fidelity: Growth Company LG 4 4 -0.3 2.3 10.5 Fidelity: Growth & LB 3 2 -0.5 5.9 7.0 Income Domestic stock fund avg. 2.1 7.9 10.2 intl stock fund avg. 3.3 17.6 19.4
*--*
*Three-year returns are annualized.
Source: Morningstar
