Your Guide To Bond Funds

New yardsticks find diamonds in the rough among some sluggish categories

Call them the ugly ducklings of mutual funds. Bond funds have been ignored by the investors. While investors hold $886 billion in bond funds, they put only $13.2 billion in new money into them last year compared with $222 billion in fresh cash that poured into equity funds. And most of that flowed to high-yield or "junk-bond" funds. Government-bond funds, with their portfolios full of U.S. government-backed debt, bled as investors took more money out than they put in. Municipal-bond funds suffered the same fate.

Are bond funds really so repugnant? By some reckonings, yes. "There's been a staggering amount of volatility considering the relatively low level of interest rates," says Kenneth J. McAlley, head of the fixed-income division at U.S. Trust Co. and senior portfolio manager for several Excelsior bond funds. "It's hard to see the next turn of events that will bring people back to bond funds."

The bond funds' recent past performance certainly won't do the job. Returns were so-so at best: an average of 6.5% for taxable funds, 3.7% for tax-exempt. Over the last five years, the average taxable bond fund earned an average annual total return of 7.6%, about half that of the average U.S. diversified equity funds.

DIVERSITY, ANYONE? But today's unloved investment often has a way of becoming tomorrow's darling. That makes bond funds worth more than just a look. And equity-fund investors whose portfolios are teeming with bull-market profits might well consider a little diversification into bonds.

That's why you need BUSINESS WEEK's Mutual Fund Scoreboard, which brings you detailed performance and operational data on 653 taxable and tax-exempt bond funds. To help you identify the best of the bond funds, we rate the funds that have at least five years of performance history. The funds with the best risk-adjusted performance earn three upward-pointing arrows (table). The scoreboard data are prepared by Morningstar Inc.

This year, we're adding some important new features as well. We've changed the way we classify funds not only by the type of bonds, such as government or municipal, but also by the maturities of the bonds in the portfolio--long-term, intermediate-term, or short-term. There's also a new category for taxable funds, ultrashort, which covers those slightly longer in maturity than money-market funds.

We are also giving funds category ratings, an assessment of the risk-adjusted performance of funds compared with others within the same category (table). These ratings use the same upward- and downward-pointing arrow system that we use for overall ratings, and can help identify stronger performers within categories. For instance, long-term government funds do not fare well when compared with all bond funds because of their high volatility. If you want to invest in this sort of fund, the category rating can spot those with the best risk-adjusted returns. Among the long-term government funds, the winner is Dreyfus 100% U.S. Treasury Long-Term Fund.

Most investors will find long-term Treasuries too risky. The market is skittish, and yields, having dipped to 6.35% in October, are near 7%. And talk of Federal Reserve tightening is in the air. But there are plenty of rewarding but far less volatile bond funds out there. "Given the economy we have, a 50-50 mix of high-yield and short-term corporate funds should work well," says Ian A. MacKinnon, senior vice-president for fixed-income at the Vanguard Group. "The combined yield would be about 7.5% and the principal risk well-controlled."

`FALLEN ANGELS.' The best place to start your bond-fund search is with the 42 funds that earned three up-arrows for their risk-adjusted returns over the past five years. Of the 23 taxable funds on the list, 20 invest in junk bonds and two specialize in convertible bonds. High-yield bonds have ratings of BB or lower, or no rating at all. Some are "fallen angels," formerly investment-grade issues whose creditworthiness deteriorated. But most of today's bonds are original-issue junk. Convertibles carry lower interest rates than straight debt because they can be converted into equity--a feature that pays off handsomely if the underlying stock does well.

It's no surprise these two categories have been so strong. Sure, they're bonds, but they also behave a lot like stocks. In fact, since 1985, the monthly returns of high-yield bonds correlate with the stock market about 52% of the time vs. a 41% correlation with 10-year U.S. Treasury bonds, according to Martin S. Fridson, chief of high-yield research for Merrill Lynch & Co.

These links to the equity market make these bonds far less sensitive to changing interest rates than investment-grade debt. While a stronger economy tends to drive up rates, better business conditions also bolster corporate cash flows--and that improves the credit rating of the junk. Better business is also a boon to corporate earnings and, thus, stock prices. That's why convertible securities, which can be turned into equities, have only a 20% correlation with investment-grade debt, according to Anne Cox, a first vice-president in Merrill's convertibles research group.

Of course, if you're looking at high-yield funds now, you're seeing them in a very favorable light. Their last bear market was 1989 and 1990, a period that saw the demise of Drexel Burnham Lambert Inc.--the junk sector's main underwriter and market maker--and a recession that pummeled many highly leveraged issuers. And because the U.S. economy is in the seventh year of an expansion, the default rate on junk bonds has also been quite low--about half the long-term average of 3%.

The next downturn in the high-yield market should not be anywhere as severe as the last. "In the late 1980s, all the big financings were from leveraged buyouts, and many of the deals depended on asset sales to pay off the bonds," notes Margaret Eagle, who's been portfolio manager of Fidelity Advisor High-Yield T Fund since 1987. "That's not the case anymore. There's less leverage, and most of the deals are coming from real operating companies."

Some portfolio managers are still a little wistful for the days when high-yield was really high-yield. "In 1990, we bought R.J. Reynolds bonds at 20% yields," recalls Ernest Monrad, who with his son, Bruce, manages Northeast Investors Trust, which earned three up-arrows not only for overall performance but also against its high-yield peers. "Now, there's nothing that pays 20% that you would want to buy." Monrad says good high-yields now pay 8% to 9%, which means it's unlikely for returns of the next five to match the last five.

Unlike many high-yield funds, Northeast Investors invests in that sector by choice and not by charter. Even with lower yields, says Monrad, junk bonds are attractive vs. other investable assets "because you start with 8% or 9% right out of the box."

Convertible bond funds, whose recent returns top even high-yields, start out with a whole lot less, perhaps 3 to 4 percentage points less yield, and hope to make it up and then some with appreciation in the underlying stock. Given the buoyant stock market, that hasn't been hard to do. And the interest-bearing coupon softens the downside risk.

"We've been able to get convertibles that go up about 75% as fast as the underlying stock, but go down only about half as much," says Hugh H. Mullin, co-manager of Putnam Convertible Income Growth A Fund, one of two convertible bond funds to earn overall ratings of three up-arrows. No doubt there would be more convertibles on that list, except that unlike high-yield, there are relatively few convertible funds to start with.

Perhaps one of the most extraordinary bond-fund performances of recent years belongs to Loomis Sayles Bond Fund. Portfolio manager Daniel J. Fuss orchestrated a 14.3% average annual total return while keeping the fund long-term in its maturities and 65% of its assets in investment-grade securities. He earned a return that's more like that of junk bonds with intermediate maturities. Few other long-term funds come close.

To earn those returns, Fuss works with a wide array of fixed-income instruments, including foreign bonds and convertibles. "We have much less correlation with the bond market than our average maturity and credit quality would lead you to think," he says. And he wouldn't mind a spike in interest rates to 7.5%, from today's 6.9%, a prospect that would make most bond-fund managers blanch. Says Fuss: "That would create a lot of discount bonds."

PENNY DROP. Among the municipal-bond funds, Debra A. Sit of the Sit Tax-Free Income Fund also manages to do what would seem to be impossible--run a long-term fund with very little price volatility. During 1996, for instance, the fund's net asset value never lost more than 3% and it finished the year only 1 cents lower than it started. Sit's secret--tax-exempt housing bonds. "The stated maturity on these bonds may be 17 years, but because they're backed by mortgages, they prepay," she says. "So you get a long-term yield with a shorter maturity."

As you peruse the scoreboard, remember that with bond funds, costs count for a lot. Pay attention to sales charges and expense ratios, both of which can take a bite out of your returns. The average expense ratio is 1.03% for taxable funds, 0.80% for tax exempt. With interest rates still relatively low and price volatility still somewhat high, the costs can make the difference between a smart and a mediocre bond-fund investment.

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