A mixed record for bonds
Bond investors, like stock investors, regained some confidence in April and May -- only to start losing it again in June.
The result was a bifurcated quarter for bond mutual funds that made for a mixed performance among fund categories.
Portfolios of high-quality bonds generally racked up negative returns in the three months as some investors pared their holdings, while funds that own higher-risk bonds, such as junk issues, scored gains as buyers returned.
In June, however, those trends reversed as concerns about the economy and the financial system resurged.
There’s another worry that may trump all others for buy-and-hold bond investors: the continuing climb in prices of commodities, including oil. That has stoked inflation, which is the biggest long-term threat to bonds because it erodes fixed-rate returns.
The trend in the market yield on the 10-year U.S. Treasury note, a benchmark for other long-term interest rates, shows the mood shifts that have rocked the bond market this year.
The T-note yield began the year at 4.03%, then sank as Wall Street’s credit crunch worsened and investors looked for a haven.
By mid-March -- just after brokerage Bear Stearns Cos. collapsed -- the yield fell as low as 3.3% as investors, fearing that the financial system could unravel, rushed into the relative safety of Treasuries.
(If nothing else, investors know the Treasury can print money to pay its bond principal and interest.)
But confidence revived in April and May after the Federal Reserve began lending huge sums to struggling banks and brokerages. Some investors began to sell low-yielding Treasuries in favor of riskier bonds, including junk issues. By late May the T-note yield was at 4.08%.
It has since pulled back, ending last week at 3.98%, amid revived fears of a severe U.S. recession that would pose new threats to the financial system.
“The consumer is in real trouble in a lot of different ways,” said Jim Kauffmann, a bond fund manager at ING Investments in Atlanta.
He notes that many Americans find their personal finances squeezed by falling home prices and banks’ unwillingness to lend, at a time when the economy is shedding jobs.
The government last week said the economy lost a net 62,000 jobs in June -- the sixth straight monthly drop.
The risk of a serious recession is causing some investors to again shun high-yield, or junk, bonds -- debt of companies that are rated below investment grade.
The average yield on an index of 100 junk issues tracked by KDP Investment Advisors fell as low as 9% early in May. By the end of the quarter, the yield had rebounded to 10.24% as investors again pulled back from the bonds. (Yields rise as bonds’ prices decline.)
Late last week the yield reached 10.39% -- the highest since 2003.
Despite double-digit yields on many individual junk issues, Martin Fridson, head of bond research firm Fridson Investment Advisors in New York, believes it’s too early for investors to jump with both feet into the junk market.
If the economy worsens, more companies are likely to find they can’t pay their debts, leading to more bond defaults, he said.
In the 12 months through May, 1.45% of junk bond issues worldwide defaulted -- a 31-month high, according to Standard & Poor’s. But S&P; expects the default rate to surge to 4.7% in the next 12 months.
“The default rate still has a long way to go,” Fridson said.
For junk bond mutual fund investors, that could mean continued rough sledding this year, depending on the kinds of bonds in their portfolios.
In the second quarter the average junk bond fund had a positive “total return” of 1.5%, according to Morningstar Inc. Total return includes a fund’s interest earnings, plus or minus the net change in principal value.
So for junk funds, the interest income earned in the quarter more than offset the drop in principal value.
But the first-half return for the average junk fund was a negative 2.1%, meaning principal losses exceeded interest earned.
Likewise, bank-loan funds, which buy pieces of corporate loans (often of high-risk companies), rebounded 4.5% in the second quarter, but still had a 1.6% loss for the half because of their dive in the first quarter.
By contrast, the average fund that owns long-term government bonds had a negative total return of 2.9% in the quarter but still was up 0.9% for the half.
Given bond funds’ struggles, it’s no wonder that many safety-conscious investors simply are sticking with money market mutual funds, which have very low risk of principal loss. Money funds now pay an average annualized yield of 1.89%, according to IMoneyNet Inc.
Money market funds took in a net $314 billion in fresh cash in the first five months of this year, while bond funds’ net inflow was $80 billion, industry data show.
But one challenge looms large for all income-focused investors: inflation -- and how the Federal Reserve and other central banks respond to it.
Driven by energy and food costs, the U.S. consumer price index was up 4.2% in the 12 months through May, compared with a 2.5% increase in calendar 2006.
Inflation eats away at bonds’ fixed returns. With inflation at 4.2%, for example, that’s more than the current 3.98% yield on a 10-year T-note.
Many central banks worldwide have been trying to combat inflation in classic fashion: by tightening credit. That drove short- and long-term interest rates up in many countries in the second quarter, hurting bonds. The average world bond fund lost 2.8% in the second quarter, according to Morningstar.
But the Federal Reserve so far has held its key short-term rate steady at 2%, although it has warned it may have to begin raising rates before the end of the year.
Bob Rodriguez, veteran manager of the First Pacific Advisors New Income fund in Los Angeles, says he is content to wait for bonds to pay higher yields.
Treasuries at these rates aren’t worth it, given inflation, he said. The yield on longer-term Treasuries would have to be at least 5% to justify owning them, in Rodriguez’s view.
“We require a higher level of compensation, i.e., more yield, for these potential risks,” he said.
For now, he advises staying in shorter-term, high-quality securities.
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