Bonds gain as fear wanes

Bond investors this year have shed much of the abject fear that gripped them in the fourth quarter.

The result was that most categories of bond mutual funds posted gains in the first quarter as bond prices either rose or didn’t fall enough to negate their interest earnings.

The exception: funds that focus on U.S. government bonds. They had been a favored hiding place during the market and economic calamity of the fourth quarter. But as fears have eased this year, some investors have been dumping government bonds, driving their prices lower and yields up.

Record government borrowing also has pushed Treasury yields higher as new bonds have flooded the market.


For other popular bond sectors, including tax-free municipals and high-yield corporate (junk) debt, first-quarter winnings provided many diversified investors with an offset to more stock market losses.

Jeffrey Gundlach, chief investment officer at L.A.-based money manager TCW Group, parent of Trust Co. of the West, says the wild sell-off in financial markets in the fourth quarter amounted to a massive “repricing” of risk. In the bond market, that meant investors suddenly demanded far higher yields on most types of bonds to compensate for the unknowns of a crashing economy.

With that repricing, “The ‘mega-risk’ has been taken out of the credit markets,” Gundlach says. In other words, investors in the first quarter were more comfortable that bond values weren’t likely to collapse again.

Instead, buyers were lured back to many types of bonds in the new year thanks to last year’s surge in yields.


Funds that own muni bonds, for example, posted total returns of 2% to 6% in the quarter ended March 31, on average, according to Morningstar Inc. Total return counts interest earnings plus or minus the net change in principal value.

It helped the bond market that the Federal Reserve continued to hold short-term interest rates at record lows, just above zero. That drove some investors to push cash into bonds in search of higher interest income.

But for financial markets overall, it’s far from certain that the first quarter tells us much about what’s to come this year -- or beyond.

One threat has disappeared for the time being but could come roaring back: the risk of rising inflation, which would erode fixed-income returns and could send interest rates soaring.


That’s the best argument for maintaining a mix of bond investments, if you can -- including shorter- and longer-term securities, and lower- and higher-risk issues.

“If ever there was a better time for diversification, I don’t know it,” said Eric Jacobson, a bond fund analyst at Morningstar in Chicago.

In the near term, however, Wall Street is focusing on what has passed for good news over the last five weeks.

Some data reports have hinted that the economy, although still contracting, may be shrinking at a slower rate. That has been enough to fuel a powerful stock market rally, which has spilled into higher-risk bond sectors such as junk.


The average junk fund posted a total return of 3.6% in the first quarter, after diving 18.5% in the fourth quarter.

Bank loan funds, which buy pieces of floating-rate corporate loans from banks, rebounded 8.2%, on average, in the quarter, after plunging 25% in the fourth quarter.

What’s more, the credit crunch that triggered the global recession has shown signs of easing -- what Fed Chairman Ben S. Bernanke has called “green shoots” in the financial system, such as the mortgage refinancing wave.

Yet many bond market pros warn that it may be far too early to be hopeful about an economic rebound.


“The green shoots are pretty small,” said David MacEwen, chief investment officer for fixed income at American Century funds in Mountain View, Calif.

“We think it’s premature to be too aggressive stepping into risk” in bonds, he said.

That means he’s cautious about corporate bonds, preferring debt of high-quality companies such as Wal-Mart Stores and McDonald’s Corp. to most junk issues, which face a rising risk of default as the recession drags on.

In the first quarter, 68 junk-rated companies worldwide defaulted on their debts, compared with 19 in the same period of 2008, according to Standard & Poor’s.


TCW’s Gundlach, too, believes the economy remains fragile, which he figures will mean more market volatility.

“There will be periods of hope followed by periods of despair -- and I see more than one period of despair ahead,” he said.

But he believes that yields on high-quality bonds, including corporates and Treasuries, are too low to make them worthwhile, despite their relative safety.

“I think you need to be selling Treasuries as a theme,” Gundlach said, echoing many other bond pros. Funds that own long-term government bonds slumped 6.7% in the first quarter, on average, after soaring 28% last year.


At the same time, if he’s right about more periods of despair about the economy on the horizon, Gundlach figures the junk bond market will be vulnerable to sell-offs that will drive up yields. Those will be good times to buy, he said.

Although more junk companies are certain to default on their debts this year, Gundlach said, he’s betting that junk bond yields in the double digits will more than compensate for default losses in a diversified portfolio -- leaving junk investors with a positive return.

Likewise, in his TCW Total Return Bond fund, which mostly owns residential mortgage-backed bonds, Gundlach says he continues to be an opportunistic buyer of higher-risk, higher-yielding bonds, because of the double-digit yields they’re throwing off.

His fund, which yields an annualized 9% based on monthly dividend payments in the first quarter, was up 2.5% in the period.


One sector that still attracts many bond pros and small investors alike is the tax-free municipal market. Munis in general offer some of the most compelling yields available.

The interest paid by funds that own only munis from California issuers is exempt from federal and state income tax for California residents. A muni fund yield of 4.5% would be equivalent to a 6.6% fully taxable yield for someone in the combined 32% federal and state tax bracket.

What’s more, California just raised personal income tax rates 0.25 of a point across the board, and the Obama administration wants to hike taxes on the highest earners. Higher tax rates automatically make munis more attractive.

Historically, few municipalities have defaulted on their debts in tough economic times. And owning munis via mutual funds provides the benefit of diversification.


Even so, some muni fund managers are playing it safer. MacEwen said he favors bonds of “essential services” providers such as the Los Angeles Department of Water and Power over debt of small cities and other issuers that may become more strapped for cash if the economy worsens.

One risk that could trip all bond investors down the road is a jump in inflation.

If the trillions of dollars the Federal Reserve and Treasury are pumping into the financial system and economy do the trick -- and pull us out of recession -- one consequence may be a classic money-driven rise in prices.

Inflation is the scourge of bond investors because it erodes fixed-income returns.


For now, the markets believe inflation will be a story for 2010 or 2011, not 2009.

But some investors already are preparing: Inflation-protected government bonds, which pay a return guaranteed to keep up with inflation, were a big winner in the first quarter. The average mutual fund that owns those securities gained 4.2% in the three months.

Morningstar’s Jacobson believes investors have the right idea adding inflation-protected bonds to their portfolios.

“This is a good time to buy a little insurance for yourself,” he says.