Searching For Safe Harbor

Here's how to find the best bond returns at the least risk

When it comes to bond mutual funds, the old rule was "yield sells." When interest rates were high, investors would buy bond funds to capture the rich payouts. So how come investors snapped up bond funds in 1998 when yields were at 30-year lows?

There's a new rule at work these days. Safety sells. And in last year's wildly swinging stock market, bond funds often seemed a welcome safe harbor. Investors poured money into bond funds at a rate not seen in years, while the money going into equity funds slipped well below the record 1997 level. Bond funds took in net cash of about $74.8 billion last year, according to AMG Data Services. That's more than three times 1997's inflows.

Are bond funds really all that safe? Not all harbors are equally protected. Last summer's global flight to quality benefited U.S. Treasury bonds the most, giving long-term government bond funds the year's best total return, up 11.7% (appreciation plus reinvestment of dividends and capital gains). The flip side of that was a flight from anything that wasn't quality. Last year, high-yield, or junk-bond, funds had their worst year since 1994, with a -0.3% total return. Emerging-markets bond funds were down more than 25% (table), which was nearly as bad as the returns from emerging-markets equity funds.

THE "A" LIST. To help you sort out the risks of bond-fund investing, we bring you the next installment of BUSINESS WEEK's Mutual Fund Scoreboard. In the tables that start on page 93, we report on 653 taxable and tax-exempt bond funds. We look at one-, three-, and five-year returns, yield, maturity, and expenses. Watch those expenses--in a low-yield world, those costs can eat into returns. And at our Web site, we have more data on these bond funds plus more than 1,100 others. All the data are prepared for BUSINESS WEEK by Morningstar Inc.

The highlight of the Scoreboard is the BUSINESS WEEK ratings. Each fund with at least five years of performance history is rated based on its risk-adjusted total returns. Those with the top risk-adjusted returns get A ratings. This year's A list has 98 funds ranging from ultrashort bond funds, whose net asset values barely fluctuate, to long-term government funds, which can gyrate considerably. What brings these funds together on this list is that they all earned superior returns for the amount of risk they took. The ratings compare taxable funds with other taxables, and tax-exempts with other tax-exempt funds. We also have a second series of ratings, which compares funds with others in the same category. So if you're looking for the best-rated international or short-term municipal bond funds, turn to the table on page 92.

NEW FUNDS. We've also made some additions to this year's Scoreboard. For starters, we've added five new categories. We separated volatile emerging-market bond funds from the more staid international funds that invest in high-quality bonds issued in developed nations. International funds earned a 9.8% total return in 1998, the second-best-performing category. They profited from a global drop in interest rates orchestrated by the central banks of the G-7 countries. Among the tax-exempt funds, we've separated California and New York--large, high-tax states with lots of funds--from the broader single-state categories and created a long-term and intermediate-term group for each.

There's more. The ultrashort bond category--funds that invest in maturities between the 90-day maximum maturity of the money-market funds and the one-year minimum for short-term bond funds--has been expanded. Our listings now include loan participation funds, which operate under slightly different rules than do the other bond funds. Like conventional funds, they issue shares whenever an investor wants to buy in. But investors can withdraw money only once per quarter and on a predetermined date. The reason for these restrictive redemption procedures is that the funds invest in senior secured bank loans, which are illiquid.

But the reward for accepting these restrictions can be sweet. The loans reset every 30 to 60 days, so the portfolio is well insulated from interest-rate swings. Depending on the borrower, the rate ranges from 0.75 to 3 percentage points above the London Interbank Offered Rate (LIBOR), a global benchmark for bank lending, now 5%.

"Our goal is to provide a consistent yield advantage over money-market funds with relative share price stability," says Payson F. Swaffield, co-manager of A-rated Eaton Vance Prime Rate Reserves. In its nearly 10-year history, the fund's net asset value has shifted between $9.95 and $10.07. Last year, its yield was 6.8%, nearly two percentage points better than the average taxable money-market fund. "This is not a riskless investment," says Jeffrey W. Maillet, who runs a competitor fund, Van Kampen Prime Income Trust. "But it is the next-best thing." Right now, the yields on these ultrashort funds compete with those on many intermediate-term funds, which are exposed to more interest-rate risk. But with ultrashort funds, yield is about all you get.

With longer-term funds, there's an opportunity for a deft manager to earn some capital gains. One fund that plays that game well is Janus Flexible Income Fund. "We don't have any rules about where we can invest," says portfolio manager Ron Speaker, "so we can take advantage of people who do." For example, "split-rate bonds," bonds that are rated investment grade by one credit agency but junk by another, are often cheap because they're off-limits to both high-quality and high-yield funds. But Speaker can buy them.

Some of our top-rated funds take diametrically opposed views. Van R. Hoisington, manager of A-rated Wasatch-Hoisington U.S. Treasury Fund, is sticking with a long-term U.S. Treasury portfolio that served him well in 1998 when the fund earned a 14.6% total return. "As long as you have a capacity glut worldwide, countries will compete by driving down the value of their currencies," says Hoisington, who adds that he sees no end to the deflationary pressure. He expects the Federal Reserve to make further rate cuts.

Taking the other view is Robert L. Rodriguez, who runs the FPA New Income Fund. He believes that inflation bottomed out last year. "Even if energy and food prices are stable in 1999, the [consumer price index] will be over 2%," says Rodriguez. He has 30% of his fund in inflation-indexed bonds. That's a position he admits he took too soon. He missed 1998's government bond rally, and the fund earned just a 3.9% total return.

GO WITH MUNIS? William H. Gross, portfolio manager for several PIMCO Funds, doesn't expect rates to move dramatically either way this year. PIMCO, with $155 billion in assets under management, is the nation's largest bond investor. "Rates should fluctuate around a fulcrum of 5%, going a little lower when the economy is weak and a little higher in periods of dollar weakness," says Gross. "This year, I expect most bond investors will just earn the coupon."

On that count, bond-fund investors might find the best opportunities in municipal bond funds. In last year's flight to quality, investors left munis for governments. But all year long, the supply of munis surged, with new issues hitting a record $280 billion. So prices sank and yields jumped--and even now remain high. "Munis are as compelling today as they were last summer," says Ian A. MacKinnon, head of bond funds at the Vanguard Group. "But the situation is not going to last." The current yield on the top-rated Vanguard Intermediate-Term Tax-Exempt Fund is 4%, the equivalent of 5.8% for an investor in the 31% tax bracket.

Alluring as yields can be, it's total return that counts. In a world of gyrating stock markets and recurrent crises in foreign economies, investors may dump bonds that continue to pay high yields in their search for safety. BUSINESS WEEK's ratings focus entirely on total return. You'll find the fund ratings--plus a whole lot more--in the Scoreboard that starts on page 93.

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