Bonds struggle for footing
Not much went right for bond fund investors in the second quarter.
The global economy continued its strong advance, which spurred key foreign central banks to raise short-term interest rates and dashed hopes that the U.S. Federal Reserve might cut its benchmark rate this year.
Meanwhile, fear of mounting losses on mortgage-backed bonds, amid rising homeowner defaults on dicey sub-prime mortgages, caused investors to demand higher interest rates on risky bonds in general.
As market interest rates went up, older bonds issued at fixed rates were devalued. The decline in principal value in some cases more than offset interest earned in April, May and June.
The result: Most categories of bond funds either had total returns (interest earnings plus or minus the change in principal) that were negative or barely positive in the quarter, according to data firm Morningstar Inc. in Chicago.
The losses weren’t dramatic, but they rarely are in bond funds. That’s just about the only consolation fund investors can take away from the period:
* Funds that own long-term government bonds had on average a negative total return of 3.1% in the three months. Long-term bonds generally fared worse than shorter-term bonds because the longer a bond’s term, the bigger the principal loss when market interest rates go up.
* Intermediate-term bond funds, which are popular with many investors and typically hold securities maturing within 10 years, had negative total returns averaging 0.7% in the quarter.
* High-yield, or junk, bond funds and emerging-markets funds, two categories considered among the riskiest bond sectors, lost principal value as market interest rates rose. But their relatively high interest earnings kept their total returns positive in the quarter.
The average junk fund eked out a 0.4% return, according to Morningstar. The average emerging-markets fund gained 0.2%.
* California municipal bond funds suffered with other bond categories. The average long-term California muni fund lost 0.9% in the quarter.
* The best return was in bank-loan funds, a fairly new breed of funds that invest in floating-rate bank loans often used to finance corporate buyouts. The funds had an average total return of 1.3% in the quarter.
What happens with bond funds in the second half of this year and beyond will, of course, depend on what happens with interest rates.
Bill Gross, who manages the Newport Beach-based Pimco Total Return fund, the nation’s biggest bond fund, has a two-part forecast on rates.
He believes the struggles of many homeowners to make their mortgage payments will be a severe-enough drag on the economy to persuade the Fed to begin cutting its short-term rate, now 5.25%, by year’s end. That could pull other rates down and push up the value of existing bonds.
“The key now is really the sub-prime market and how it affects the economic fundamentals and consumption,” says Gross, whose Total Return fund lost 1.4% in second quarter.
But longer term, he worries that the strength in the global economy will mean higher interest rates. The yield on the 10-year Treasury note, which is a bellwether for other long-term rates and ended Friday at 5.18%, could reach 6.5% in the next five years, Gross says.
For investors who own bond funds as a hedge against a potential plunge in other parts of their portfolio, such as stocks, there may be no reason to dump bonds now, financial advisors say. Fixed-income investments still provide a portfolio buffer in times of market turmoil, and high-quality bond funds typically don’t own the sub-prime mortgage bonds that are most at risk from the housing crunch.
Even so, some investors understandably are quite happy to keep the fixed-income portion of their assets in money market funds, which currently pay an average annualized yield of 4.68%, according to iMoneyNet Inc. of Westborough, Mass.
And unlike most bond funds, money funds have virtually no risk of principal loss because they own only very short-term government and corporate IOUs.
Meloni Hallock, chief executive of Acacia Wealth Advisors in Century City, said her clients were about split on whether to use money market funds or longer-term bonds for their fixed-income investments.
“Ordinarily you’d say go out a little longer for those assets,” she said. “But many people are more skittish now. So I’m seeing a lot more money sitting in cash.”
Some advisors favor short-term bond funds, which invest in securities maturing in one year or less. That’s the strategy of Phil Kruzan, a principal at advisory firm Foster Group in West Des Moines, Iowa.
“We use bonds to reduce volatility in a portfolio. It’s not necessarily about yield enhancement,” he said.
The good news in rising interest rates on bonds is that investors who have been waiting for more attractive yields finally are getting them.
As bond fund prices have dropped, new buyers are earning higher yields than they might have gotten just six months ago.
The question is whether those yields will get even better, if the economy keeps rolling.
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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 June 30. Figures
for periods longer than one year are annualized averages. For category descriptions and the bestperforming
funds in each category, see tables on Pages C9-10.
*--* Total Annualized Category return total 12-mo. return: Category symbol 2nd-q. YTD 3-yr. 5-yr. yield Bank loan BL 1.3% 3.4% 5.6% 5.9% 6.6% Ultra-short-term UB 0.9 2.1 3.3 2.7 4.7 Short-term investment grade CS 0.4 1.7 2.9 3.0 4.2 High-yield (junk) HY 0.4 3.0 8.1 10.4 6.8 Muni short-term (national)* MS 0.2 1.0 2.3 2.2 3.1 Emerging markets EB 0.2 2.4 13.5 15.5 5.5 Short-term govt GS 0.2 1.5 2.7 2.6 4.2 Multi-sector MU 0.1 1.8 6.8 8.7 5.1 High-yield muni HM -0.4 0.6 6.5 5.9 4.4 Muni California intermed.- /short-term MF -0.4 0.2 3.1 3.0 3.4 World IB -0.6 0.7 4.3 6.5 2.9 Muni intermed.- term (national)* MI -0.7 0.0 3.2 3.4 3.6 Intermed.-term investment grade CI -0.7 0.7 3.6 4.3 4.5 Intermed.-term government GI -0.7 0.6 3.0 3.2 4.4 Muni single-state long-term* SL -0.8 -0.2 3.9 3.9 3.8 Muni long-term (national)* ML -0.8 -0.2 4.1 4.0 3.8 Muni California long-term* MC -0.9 -0.2 4.6 4.3 3.9 Inflation-protec ted bond IP -1.0 1.2 3.0 5.3 3.7 Long-term investment grade CL -1.1 0.0 4.8 6.9 5.2 Long-term govt. GL -3.1 -2.2 4.4 5.7 4.4 Govt. bond fund average -0.7 0.8 3.0 3.2 4.2 Corp. bond fund -0.1 1.6 4.7 5.7 5.1 avg Intl. bond fund -0.4 1.1 6.5 8.7 3.5 avg
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*Because interest on municipal bonds is tax-exempt, effective returns can be higher than stated returns and will depend on an investor’s tax bracket.
Source: Morningstar
