Bond Funds: Nowhere To Go But Up?

For the bond market, 1994 will go down in infamy. The debacle was the worst in 60 years. Investors who thought they were being prudent by buying bond funds discovered to their horror that even the highest-quality portfolio lost value in the face of rising rates. After pouring $113.6 billion into bond funds in 1993, investors did an about-face. They took $43.5 billion more out of the funds than they put in.

But the case for buying bond funds now seems persuasive. The Federal Reserve, which engineered the rise in interest rates to head off inflation, appears have done the job--and the end of rate hikes is at hand. Funds with short-to-medium maturities look especially attractive. For a five-year bond to lose money over the next year, interest rates would have to top 10%, says Robert L. Rodriguez, portfolio manager of the FPA New Income Fund. "There are some good values in the bond market today," says Rodriguez. Adds Ian A. MacKinnon, the bond-fund chief at the Vanguard Group: "It's time to start buying again."

But which funds? Why not the best? We identify them in BUSINESS WEEK's Mutual Fund Scoreboard. We now report on 652 bond funds, nearly 100 more than last year. We examine how they performed not only in 1994 but during the last three- and five-year periods as well. For funds with at least five years' history, we assign ratings based on their risk-adjusted returns during the 1990-94 period. Thirty-eight funds, both taxable and tax-free, earned three upward-pointing arrows, the highest BW rating (table). The data in the Scoreboard are prepared for BUSINESS WEEK by Morningstar Inc.

These top-rated funds performed relatively well in 1994's bear market. Of course, in absolute terms, the returns were poor. The average three up-arrow fund lost money, with a -0.4% total return (appreciation plus reinvestment of dividends and capital gains). Only 16 posted a positive return. The best fund was the Strong Advantage Fund, up 3.6%; the worst of the best, Fidelity Aggressive Tax-Free Portfolio, had a -5.9% return. Both funds have been on the top-honors list for several years, and in fact, 23 of this year's 38 highest-rated funds are holdovers from last year. The average return from the prior top-honors list-- covering the 1989-93 period--was -2.5%.

CASUALTIES. If the performance of the top-rated funds is disappointing, consider that the average bond fund in the Scoreboard delivered a sickening -4.9%. Even funds that invest in adjustable-rate mortgages, which are supposed to protect investors' principal when interest rates are rising, in the main failed to do the job, although a few did rise to the occasion. One such fund, Smith Breeden Short Duration U.S. Government Fund, had the best results of any Scoreboard fund, up 4.3% for the year. Only 5% of the Scoreboard funds even finished in the black for 1994.

Although derivatives grabbed the headlines last year, the worst derivative-related damage was confined to a handful of funds. The two funds hit the hardest by derivatives are institutional funds not covered in the Scoreboard. One individual investors' fund, PaineWebber Short-Term U.S. Government Income Fund, had a -4.3% return. Results would have been worse if PaineWebber Inc. had not taken some of the worst derivatives off the fund's hands.

Derivatives claimed some real casualties among the tax-free funds. The New York Muni Fund posted the worst muni showing of the year, down 20.4%. That's because as interest rates began to rise in early 1994, the fund had nearly half of its assets in inverse floaters--and the value of those securities plunged faster and further than those of conventional coupon bonds. California funds performed poorly, too, not so much because of their own derivatives, but because of Orange County's. The county was forced into bankruptcy because of investment losses created by derivatives and excessive leverage. And bonds of Orange County issuers slumped in price.

DICEY PURCHASES. Of course, derivatives are not all bad. The question is how a fund uses them. For instance, Kevin Grant, portfolio manager of the Fidelity Mortgage Securities Fund, invested 2% of the fund's assets into interest-only mortgage securities in late 1993, as rates were bottoming out. "They were very cheap," recalls Grant. "When rates are low, nobody wants them." But as rates rose, so did the value of those IOs. Higher rates mean fewer homeowners would refinance mortgages, and interest payments would last for a longer period. Grant says they added 2 percentage points of return, the difference between a profit and a loss for the year.

The year's worst performers were the world bond funds, with a -8.2% average return. Those with large holdings in emerging markets were in the red even before the Mexican currency crisis. Alliance North American Government Income Fund, stuck with hefty helpings of Latin debt when the crisis hit, had a total return of -30.8% even considering a plump 14.3% yield. Ironically, until the fourth quarter, that fund was one of the best-selling bond funds of the year, according to Financial Research Corp.

Buying bond funds for yield alone can be dicey. So if you're thinking about investing in bond funds, start your shopping among the funds with three up-arrow ratings. They've earned these not because they paid out the most money, but because they earned the highest returns for the amount of risk they took.

The list is dominated by funds that keep their portfolios in the short-to-intermediate maturities. True, long-term funds often have the highest yields, and when interest rates fall their value jumps. But over the long haul, the longer-term funds don't necessarily return a whole lot more. For instance, Vanguard Fixed-Income Short-Term Corporate Bond Fund, a three-up-arrow fund, delivered a 7.2% average annual total return for the last five years vs. 8.9% a year for the Vanguard Fixed-Income Long-Term Corporate Bond Fund. Yet the short-term fund is the better investment. That's because it has 80% of the return of the long-term fund with about one-third the risk (box, page 96).

That's a point often lost on yield-hungry investors. Long-term bonds can be as volatile as equities, but they don't have nearly the same payoff potential. "If you really want to earn money, go to equity funds," says investment adviser Tim C. Medley, of Medley & Co. in Jackson, Miss. "For bonds, stick to the short term."

If stretching for yield by taking on interest-rate risk does not pay, the top-performers list suggests that taking on some credit risk does. Four of the top funds are high-yield corporate funds, or "junk bond" funds. These earn higher returns by taking on the risk that the issuers can make good on their debts. Such funds can also balance an investment-grade portfolio. When rates rise, junk bonds tend to fall less than high-grades. That's because a strengthening economy that raises rates also boosts corporate cash flows--and the creditworthiness of lower-rated borrowers.

RARE BIRD. High-yield muni-bond funds have often shown a positive mix of risk and reward, because they earn higher yields by investing in unrated bonds. Many smaller issuers find it cheaper to pay a higher rate on their bonds than shell out for a credit agency's rating. So for fund managers who can perform the credit analysis themselves, like American Capital Tax-Exempt High-Yield Municipal A, unrated bonds can be golden. But high-yield muni funds pick up some of their extra yield by taking on longer-maturity securities. So their 1994 returns suffered more from rising rates than did high-yield corporates.

One of the more unusual funds on the top-honors list is FPA New Income Fund, a taxable-bond fund with an average annual total return of 9.8% over the last five years and a 1.5% return in 1994. Unlike most bond funds, which are segmented by market (such as government or high-yield) or maturity (short, intermediate, or long-term portfolios), portfolio manager Rodriguez has wide latitude: The portfolio's average maturity can be as short as two years or as long as 10. As interest rates hit record lows in 1993, Rodriguez refused to buy bonds and took the portfolio down to its minimum maturity. That kept him in good stead when the market plunged. Since midyear, he has been slowly lengthening the maturity of the fund by adding 15-year zero-coupon bonds and 10-year U.S. Treasury notes.

Before you invest, consider your tax status. Tax-exempt funds were even harder hit last year than taxables, and yields on munis are more than 80% of those on taxables of comparable maturity and credit quality. That means nearly all investors--anyone in a 28% or higher tax bracket--could earn a higher yield in muni funds. For tax-deferred accounts, taxables are the way to go.

What's also critical are sales charges and expenses. For instance, FPA New Income is a fine fund, but it has an upfront 4.75% load. That may dissuade some investors. But an upfront load is a one-time charge. More troublesome are high expense ratios--money that comes out of the fund every year to pay for management, operations, and for funds with 12(b)-1 fees, a salesperson. That's why it may be wise to pass on Venture Muni (+) Plus B, despite its three-up-arrow rating. It has a steep 2.08% expense ratio--$2.08 for every $100 in the fund. By comparison, the expense ratio for the average tax-free fund is 0.82% and the average taxable fund, 1.06%

Such details may sometimes count as much as performance. You'll find all the data you need in the Scoreboard that begins on page 97.

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