The Best Bond Funds

With stocks losing their sparkle, it's time to take a look at a much neglected alternative

When the stock market soars, even a mediocre equity mutual fund can make the best bond fund look like an also-ran. No wonder that only 10% of the some $650 billion pumped into mutual funds since 1995 went to bond portfolios.

But with the stock market struggling and inflation much subdued, it's time to consider investing in bond funds. And that's where BUSINESS WEEK's Mutual Fund Scoreboard comes in. Here you'll find detailed performance and operational data on 653 taxable and tax-exempt bond funds. When you visit BUSINESS WEEK Online, you'll find data on those and about 1,100 additional bond funds on our new Interactive Mutual Fund Scoreboard. And, of course, there's data on some 2,300 equity funds as well. The Scoreboard data are prepared by Morningstar Inc.

To help you identify the best bond funds, we rate those that have at least a five-year history. Right now, that's an especially good period to look at. Three of those years--1993, 1995, and 1997--were characterized by falling interest rates and rising bond prices. But 1996 showed mixed results, and 1994 was the bond market's worst year in six decades. Looking back, you can see how funds behaved under the best, worst, and just middling circumstances.

TAX NOTICES. The 83 funds with the best risk-adjusted returns when compared with all other rated bond funds earn an A for overall performance (table, page 113). Bond funds are also rated against funds with the same investment characteristics, and you'll find these categories in the table on page 114.

The downtrend in long-term interest rates last year--they declined from just over 7% in April to 5.8% by yearend--allowed both taxable and tax-free bond funds to generate average total returns of 8.3% (including reinvestment of dividends and capital gains). The rate drop was golden for the longer-term funds, whose bonds have the longest maturities and thus benefit most from declining rates. The best showing came from American Century-Benham Target Maturities 2025 Portfolio, a zero-coupon fund whose bonds pay nothing until they mature in 2025, which delivered a 30.1% gain. But that's a fund which, if rates went up, could just as easily lose 30%.

Most bond funds don't swing that much. Income is the major component of their returns, though if rates move enough, they may produce capital gains or losses. Even shareholders in tax-exempt funds are now receiving 1099s advising them they earned capital gains last year--and no, they're not tax-exempt.

WEATHER EYE. While bond funds are less risky than equity funds, it still pays to seek those with the highest risk-adjusted returns. The potential upside from bonds is far less than from stocks, so you want to be sure fund managers are delivering the maximum return for the risk they take. That's why you should start your bond-fund search with the A-list funds.

Among the taxable funds, high-yield funds dominate. The junk bonds they buy are below investment grade, so they pay higher rates to compensate for greater credit risk. But that's not all. The long profit boom that fueled the stock market also bolstered most junk-bond issuers. The bonds appreciated from their improved credit quality, and the default rate was halved. Indeed, high-yield bonds have a higher correlation with stocks than with Treasuries.

But the linkage with the equity market may make these funds less attractive now. "We're starting to see some of the pressure that's on the equity market spill over to high-yields," says Thomas T. Sorviero, portfolio manager of the A-rated Fidelity Spartan High-Income Fund. But Sorviero says he prepared for this by deemphasizing bonds from global industries such as paper, energy, and steel, and emphasizing the more domestic broadcasting, cable, and telecommunications issuers. Two other Fidelity high-yielders, Fidelity Advisor High-Yield T and Fidelity Capital & Income, also made this year's A-list. The three Fidelity funds have different managers, but they all draw on the company's formidable research staff.

The stock market's fortunes may also cloud the picture for convertible bond funds--which are even more dependent on the stock market than high-yields. That's because convertibles pay a low interest rate in exchange for the ability to convert the bond into equity. But Richard Janus, portfolio manager of the A-rated Key SBSF Convertible Securities, thinks converts are well-suited for today's environment. "In an equity market with a gentle upward or downward bias, we'll do just fine," he says. "And we'll lose less money than stocks in a bear market. But there's no way convertibles can keep up with the stock market when it's up 30%."

Well, Andrew Davis of top-drawer Davis Convertible Securities A came darn close. The fund earned a 27.8% total return, vs. 33.4% for the S&P 500 and 17% for convertible funds. His secret? "The 80-50 rule," says Davis. "I don't invest in a convert unless I believe it will give me at least 80% of the return of the common stock and no more than 50% of any losses on the common."

Investors looking to diversify away from the equity market may choose an investment-grade or even government bond fund, especially if they fear a slower economy ahead. You won't find those funds on the overall A list this year, but in the category ratings (table). In the general bond area, check out Dreyfus Short-Term Income, Strong Corporate Bond, and Invesco Select Income. For government funds, Sit U.S. Government Securities and Fidelity Mortgage Securities are among the highly rated.

RULING FUNDS. Among the top-performing tax-free funds, Franklin funds rule. In part, that's because Franklin Resources Inc., based in San Mateo, Calif., with $49 billion in tax-free bond funds, is by far the largest in the business and thus has more funds to rate. Franklin's huge asset base affords it a large in-house research effort and gives the company a seat at the table when investment bankers and issuers are putting together a muni bond deal.

But that's not all. Thomas Kenny, who heads municipal bond research at Franklin, says the firm's managers stress income, not total return. So Franklin always buys current coupon bonds at or near par. When rates are falling, says Kenny, many fund managers buy lower-coupon discount bonds, which will score capital gains if rates fall. "If the market rallies, we'll lag," he admits. "But if rates rise, we won't be hurt as much. And we're still getting those higher yields."

Franklin's funds come at a price. They're broker-sold and have sales charges. But price-sensitive fund investors can find plenty of no-load fund managers, such as Vanguard Group, which also show they can deliver exceptional risk-adjusted returns.

Get acquainted with the bond funds by turning to the Scoreboard, page 115.

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