Can Bond Funds Do It Again?

They beat equity funds hands down in 2000. Here's our guide to the best

Admit it. You're a recovering equities junkie with a newfound respect for safer investing. Of course, taking it on the chin in tech stocks last year isn't the only reason you should be in bonds. With the stock market's recent undoing, what investors can turn up their noses at risk hedging, steady returns, and decent yields?

Still, if you're like most other investors, weaning yourself off stocks isn't so easy: Investors pumped $297.4 billion into equity mutual funds last year through November, while yanking $47.6 billion (mostly during the first half of the year) out of fixed-income funds, reports the Investment Company Institute, the industry's trade group. They made a big mistake: The return on the Lehman Brothers Aggregate Bond Index, a broad measure of bond market performance, was 11.63% at yearend, and U.S. Treasury long-term bonds in particular rose 13.52%. The average bond fund was up a tidy 8.2% in 2000, while most equity mutual funds lost money. That's the best turnout the sector has had since 1995, when bond funds soared an average 16.4%, including dividends and capital-gains distributions.

Equity-centric investors have been caught off guard. But looking for full-throttle returns from bond funds now is a mistake. Expecting that they're free from risk is equally wrong. If you want to get started with fixed-income investing, or plan to beef up an existing bond portfolio--you'll find this BusinessWeek Mutual Fund Scoreboard a handy place to begin your research. The 16th annual Scoreboard series kicked off last week with a detailed report on the best equity funds. It concludes with closed-end funds coverage next week.

Flip to page 76, and you'll get the lowdown on 333 of the largest taxable and tax-exempt funds. You'll find one-year, three-year, and five-year total returns. (Total return includes appreciation plus reinvestment of dividends and capital gains before taxes.) To help you comparison-shop, we provide data on yield and maturity, as well as sales charges and expenses, which average 0.99% for taxable and 0.89% for tax-free bond funds. Your investing time horizon will dictate ideal yields and maturities, and knowing costs is critical: Expenses can quickly eat into a bond fund's returns.

Our Web site at picks up where the magazine leaves off, with 1,255 more funds in an interactive version of the Scoreboard. Online, you'll find tools to screen funds by various criteria. All data were prepared for BusinessWeek by Standard & Poor's Corp., which is also owned by The McGraw-Hill Companies.

The highlight of this issue is the exclusive BusinessWeek seal of approval: the A rating. Relatively few bond funds--104 of 1,588--earn it. Those that do have at least five years of performance history and are ranked according to the risks taken to achieve returns. Risk is calculated by subtracting the monthly Treasury bill return from the fund's total return for each of the 60 months in the rating period. When a fund underperforms T-bills, the result is negative. The more negative results over the five-year period, the riskier the fund. We've divided ratings into taxable and tax-exempt funds and have also rated funds against others in their category.

The best returns in 2000 were harvested mainly by investing in high-quality government bonds. A buyback program that would trim the supply of long-term Treasuries helped to spur the rally on: The 10-year Treasury bond began the year yielding 6.44% and ended at 5.11%, as investors bid up the price, driving down the yield. Long government bond funds were the best-performing category, up 14.1%, while intermediate government funds rose 10.8%.

FEWER MUNIS. Quality was the name of the game last year for co-manager Michael Hoeh of the Dreyfus Short-Term Income Fund. He raised "agency securities"--those backed by U.S. government agencies--to 40%, up from 10% of assets last year. The fund, which yields 6.5%, showed a total return of 8.9% last year. "At the end of the second quarter it was clear the economy was slowing and there were increased bankruptcies in the corporate market," says Hoeh, whose fund is a repeat A-list performer. "A move to higher credit qualities really paid off."

You'll also find a slew of municipal bond funds on the A-list. They've ticked up with a dwindling supply of new muni issues and relatively strong local economies. In contrast, tight monetary policy and the evaporation of capital from Wall Street and banks hurt returns from both investment-grade and high-yield corporate debt. Few bond funds investing in risky issues are A-rated. That's a far cry from 1999, when convertible-bond funds posted the highest absolute returns of all bond funds. But just as easily as these hybrid investments gained on a booming equity market in the past three years, performance sank as the market reeled. Only two convertible funds, down from 10 in 1999, make the A grade this year, but the group's long-term gains still hold: Convertible-bond funds' three-year returns at 11.5% and five-year returns at 13.3% trounce other categories.

"GOOD UPSIDE." The two convertible bond funds that earn high marks are both products of Calamos Asset Management Inc. in Naperville, Ill., which manages $6 billion in convertible portfolios. Consistent top performers, the Calamos Convertible and Calamos Convertible Growth & Income funds shed telecom companies, such as Qualcomm Inc. (QCOM), and trimmed back tech stocks like Veritas Software Corp. (VRTS) going into 2000. The assets were reinvested into slower-growth companies, such as ACE Ltd. (ACL) and Metropolitan Life (MET). It's not that John P. Calamos, the firm's chief investment officer, was making a market call, he says, but rather that he was paying attention to how close to par the bonds were trading. "We had some good upside, and we knew we had to lay off," said Calamos, who runs the funds with his nephew Nick and his son, John Jr. The Calamos team is now selectively buying below-investment-grade bonds and banking on a soft landing for the economy. Still, Calamos is "long-term bullish and short-term scared all the time," he says. "It's a risky area, so we're trying to do our homework and be careful."

Sensitivity to risk is a fundamental character trait in bond managers. But another commonality among superstars is the inclination to look below the surface of traditional fixed-income securities. Many winning fund managers dabble in arcane instruments that require in-depth research. Take Michael C. Brilley, chief fixed-income officer at Sit Investment Associates Inc. in Minneapolis and co-manager for the A-rated Sit U.S. Government Securities Fund. The fund's "long government" classification is a bit of a misnomer. Its style is not to buy traditional, single-family mortgage-backed securities of the Ginnie Mae or Fannie Mae variety. Instead, the fund buys mobile-home and manufactured-housing debt, which matures in 5 to 15 years. These bonds are, in general, shielded from refinancings, defaults, and prepayments for several reasons. Mobile homes depreciate, so it's more difficult to refinance and the interest tends to be high. That eliminates some key risks in other, more mainstream, mortgage-backed securities. Although "these aren't your best credits," Brilley says, "they are high-coupon mortgage loans with a very low degree of refinancing activity."

CREDIT CRUNCH. Some of the most successful municipal bond managers also buy sophisticated debt instruments. The $2.6 billion USAA Tax-Exempt Intermediate-Term Fund, a national muni bond fund, for example, has a healthy 20% stake in booming New York State. But it also invests 20% of assets in municipal sinking fund bonds, which are safer because they're "insured" with a custodial account used for redemptions and buybacks. Sinking funds tend to have a short duration and are ignored by most other managers, says USAA manager Clifford A. Gladson. "We're always looking for deals that may take a little more time to understand--that are a little harder to value." That doesn't mean Gladson ignores risk: The fund holds 200 sorts of issues, representing debt from nearly every state in America.

Wall Street mergers and tight lending standards led to a credit crunch and a crimp on corporate bond performance last year. A sagging equity market did not help: High-yield bonds lost an average 8.1% in 2000, pulling down the average three-year result to a 1.7% loss. Jeffrey A. Koch, manager for the Strong High Yield Bond fund, an A-rated fund, navigated the stormy markets by trimming telecom and tech at the start of 2000. A "complete washout with indiscriminate selling" in November prompted him to get back into the junk bond game. "We've finished with the bear phase of the high-yield market," says Koch. The Strong fund, which yields more than 12.6%, ended the year at $620 million and now stands at $850 million, after a rush of new cash and market appreciation. Koch is looking for companies moving to reduce debt or raise asset value, citing Level 3 Communications Inc. (LVLT) and Williams Communication Group Inc. (WCG) as two such examples. "These are asset-rich companies with seasoned management," he adds. "The prospects are good."

Bond funds won't give you the rush equities can when the going is good. But they sure do deserve a place in the portfolio of savvy investors--especially when the going gets rough.

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