The Few, The Proud...The Profitable

After a bad year, opportunities in muni and high-yield funds

When the stock market is sizzling, bond mutual funds are a hard sell. So what chance do bond funds have of attracting new investor dollars if interest rates are rising, prices are falling, and net asset values are shrinking? Not much. No wonder the cash stream going toward bond funds nearly dried up last year. For municipal-bond funds, it was even worse, with investors taking more money out than they put in--a trend that has continued into the new year.

Sometimes the best opportunities are in what's ignored or even shunned, and that's why bond funds deserve your attention. To do that, we bring you the bond-fund installment of the BUSINESS WEEK Mutual Fund Scoreboard.

In the tables that start on page 107, we report on 653 taxable and tax-exempt funds. We examine one-year, three-year, and five-year total returns. (Total return includes appreciation plus reinvestment of dividends and capital gains before taxes.) We report on portfolio data such as yield and maturity and operational information such as sales charges and expenses. And on BUSINESS WEEK's Web site,, additional data on these funds and nearly 1,100 more in an interactive Scoreboard allow you to screen funds using various criteria (click here for additional data). All the data are prepared by Morningstar Inc.

HONOR ROLL. BUSINESS WEEK also delivers something unique: our own proprietary mutual-fund ratings. Each fund with at least five years of performance history is rated on the basis of its risk-adjusted total returns. Those with the best risk-adjusted numbers earn A ratings.

This year, 104 bond funds earned A's (table, page 105). They are a varied lot, ranging from funds with ultrashort maturities like Strong Advantage and SSgA Yield Plus, which take almost no interest-rate risk, to Franklin High Yield Tax-Free Income A and Scudder High-Yield Tax-Free, which hold portfolios of long-term bonds that can get clocked when rates go up. The list also includes funds that prefer taking credit risk to interest-rate risk, such as MSDW Prime Income Trust Fund and Columbia High-Yield Fund. Some of the A-list funds, mainly ones for munis, actually lost money last year. Still, what all have in common is a high amount of return relative to the risk they took with your money.

The A list also includes 10 convertible-bond funds, which posted the highest absolute returns of them all. That's because convertible bonds are linked in value to the issuer's stock price. If the stock shoots up, the convertible can share in the price gain. "With convertible bonds, we hope to capture 75% of the upside potential in a stock but have only 25% of the downside," says John P. Calamos, manager for three convertible-bond funds which all earned A ratings on the BUSINESS WEEK Scoreboard. The best-performing of them was Calamos Growth & Income A, up 52.9% in 1999, and an average of 27.9% a year over the last five years.

With the help of the stock market, the convert funds trounced the other sorts of bond funds over the periods of one, three, and five years (table). The 31.9% total return earned last year was just a bit better than the average equity mutual fund (BW--Jan. 24). Emerging-markets bond funds looked smart last year, up 25.9%. But that was after two years of horrid returns. In fact, the three-year average annual return for these volatile funds is just 1.7%. For 1999, the average taxable bond fund earned just 1.3%. Tax-free funds were even worse, with returns of -3.5%.

All told, last year was the worst for bond funds since 1994. That's because interest rates have been on a steady climb since the October, 1998, lows set in the aftermath of the Russian-debt default and the near-collapse of Long-Term Capital Management. By the start of 1999, the 30-year long-term U.S. Treasury bond yielded 5.1%; the 10-year posted 4.6%. Neither was expected to move much higher.

The pundits were wrong. The U.S. economy strengthened as employment, consumer spending, and business investment kept climbing. The global economy also picked up, and many investors sold bonds and dollars to seek opportunities outside the U.S.--sending bonds reeling and interest rates higher.

TIGHTENING UP. While inflation was not--and is still not--a problem, the Federal Reserve starting raising short-term interest rates to try to cool the economy and prevent inflation from taking hold. The central bank raised short-term rates 0.75% in three quarter-point increments. By yearend, the 30-year Treasury yield was 6.49% and the 10-year, 6.44%. By Jan. 18, the yields on both were 6.74%.

And the Fed isn't done yet. The market has already figured on another quarter-point hike in early February and one in mid-March. And some bond-fund managers, such as Jeffrey A. Koch of the A-rated Strong Advantage Fund, think there could be a couple of more turns of the monetary screws this year before the central bank is done. "Long-term rates are attractive at current levels," Koch says, "but it may be a tad early to move into longer-term bonds." The current yield on Koch's fund, which holds, on average, A-rated bonds, is a generous 6.9%. With a portfolio maturity of less than one year, there's little damage to be done if rates move higher.

Some big investors are starting to lengthen their portfolios in anticipation that interest rates are at or near a peak. "There's already a lot of bad news on inflation that's built into the current level of rates," says Ian A. MacKinnon, who oversees bond fund management for Vanguard Group. "We've backed up nearly two percentage points from the low in interest rates, while the rise in inflation rate is less than half of that."

William H. Gross, who oversees some $180 billion in fixed-income investments for PIMCO Advisors, also believes that, with long-term rates near 7%, bonds are attractive. "That's a yield you would expect with a 3% inflation rate, and we don't have that," says Gross, who runs four of the funds on BUSINESS WEEK's A list. "In fact, we believe that the U.S. and global economies are in a disinflationary mode."

Better opportunities might be found in other sorts of bond funds, especially those that invest in tax-free bonds. They were especially bludgeoned last year, hurt both by rising rates and a glut of supply that came to market as issuers rushed to get their Y2K-funding needs met ahead of schedule. That supply was coming on line as investors were bailing out of the funds--some $1 billion a week in net outflow in the latter part of the year, according to AMG Data Services, which tracks flows to funds.

BARGAIN MUNIS. The upshot is that many muni bonds are cheap, trading at 95% or so of the yield on the comparable taxable Treasury bond. With a dearth of supply this year, any incremental pickup in demand will send prices higher--and give muni funds a chance for some modest capital gains. In the meanwhile, yields aren't bad, either: about 5% for intermediate-term funds. To beat that with a taxable bond, an investor in the 31% tax bracket would need to earn 7.25% or more.

The only way to do that is in a high-yield fund--another sector under pressure from rising interest and default rates. That pushed yields on the bonds to between 9% and 11%, which makes them attractive relative to other taxables. Defaults? Not a problem for a fund with a good research capability. "As long as the economy is fairly healthy, high-yield does well," says Tom Sorveiro, portfolio manager of the top-rated Fidelity High-Income Fund.

Even if interest rates are peaking, neither Gross nor MacKinnon foresees a big bond rally. "Stocks rule the day," says Gross. "There's no bull market in bonds until investors start to lose interest in stocks." Most likely, says Gross, bond investors will earn a total return equal to the yield on their bonds. That may not sound like much, but after the drubbing bonds took in 1999, it will no doubt be a welcome relief.

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