Time to exit bond bunker?
Boring U.S. government bonds showed their best quality in the third quarter: They’re a place to hide when things get scary in financial markets.
On the flip side, losses in corporate junk bonds and other lower-quality debt demonstrated why risk is a four-letter word.
The question now for income-oriented investors is whether there still are good reasons to be afraid for markets and the economy, or better reasons to think the worst has passed.
Rising mortgage defaults helped trigger a severe global money crunch in July and August as many banks and investors pulled back from extending credit. One result was a dramatic “flight to quality”: Many investors rushed into U.S. Treasury securities and government bonds of other major countries as a haven.
As buyers bid up prices of those bonds, the yields on the securities tumbled. The 10-year Treasury note yield slumped from 5.03% on June 30 to 4.59% on Sept. 28, and in mid-September fell as low as 4.32%.
The rally produced a “total return” -- price change plus interest income -- of 5.3%, on average, for long-term government bond mutual funds in the quarter, according to Morningstar Inc. That was more than five times the gain of the average U.S. stock fund in the period.
Funds that own other types of high-quality bonds also generated positive returns in the quarter, thanks in part to expectations that the Federal Reserve would cut short-term interest rates to ease the credit crunch.
And the Fed didn’t disappoint: On Sept. 18 it cut its key rate from 5.25% to 4.75%.
Since then, however, the credit crunch has continued to abate and data on the domestic economy have suggested that the pace of growth is slowing but isn’t collapsing. On Friday the government said the economy created a net 110,000 jobs in September, meeting analysts’ expectations.
That leaves bond investors wondering what the Fed will do next. If policymakers continue to cut short-term rates, yields on longer-term bonds also may decline. At the same time, more Fed cuts would drag down yields on money market funds and bank savings certificates, which could drive investors in those accounts to try to lock in longer-term yields.
Many analysts are sticking with the view that the Fed is more likely to cut rates in the months ahead than hold steady or raise them.
“The economy is slowing down, but it’s a gradual process,” said Ethan Harris, economist at Lehman Bros. Holdings Inc. in New York. He expects the Fed’s key rate to be at 4% by mid-2008.
Shorter-term Treasury yields also suggest that investors are betting on more rate cuts. The two-year T-note yield rose Friday, but at 4.07% it was well below the Fed’s rate.
The 10-year T-note yield, at 4.64% on Friday, also was below the Fed’s rate.
The relatively low level of high-quality, longer-term bond yields raises a question about how much more room they have to fall even if the Fed eases short-term rates further.
Jeff Tjornehoj, an analyst at fund tracker Lipper Inc. in Denver, said he favored money market funds over high-quality bonds because he didn’t see the potential for a big drop in long-term yields.
Many investors must share that view: Assets of money market mutual funds have rocketed to a record $2.8 trillion, from $2.5 trillion at the end of June, as more investors have opted to play it safe. The average annualized seven-day compound yield on taxable money funds was 4.63% last week, according to IMoneyNet Inc. That yield is expected to drift lower as the Fed’s mid-September rate cut works through the financial system.
If nothing else, the rush of money into government bonds in July and August showed how they can play the role of a bulwark in a portfolio, rising in value during a market panic and at least partly offsetting losses on stocks and other higher-risk assets.
If the global credit crunch worsens again, or economic data turn grim, high-quality bonds would be the most likely beneficiaries.
Jim Freeman, head of financial advisory firm Financial Alternatives Inc. in La Jolla, Calif., said investors with government bond funds and other high-quality issues should realize that “you’re really just reducing the risk in the portfolio” -- but that, at current yields, you aren’t earning much of an interest return.
As for higher-risk bonds, such as junk issues, they have been recovering since mid-August as credit-crunch worries have dimmed. But the average junk bond fund still was in the red at the end of the quarter, producing a 0.1% negative total return for the period, according to Morningstar.
Hit even harder in the quarter: bank-loan funds, which invest in syndicated bank loans often used to help finance corporate buyouts. The average bank-loan fund sank 1.6% in the quarter.
The junk-bond and bank-loan sectors may rally this quarter if the economy stays reasonably healthy, some analysts say. But many also warn that those sectors will be fighting a head wind, in that the number of companies defaulting on their debts is expected to begin rising from what have been record low levels.
“Corporate credit risk is on the rise,” bond-rating firm Standard & Poor’s warned clients in a report last week. As investors remain skittish about lending money, S&P; said, “the weakest firms will have trouble accessing capital to prevent default if market conditions remain static or worsen.”
