The Suddenly Sexy...Government Bond

Compared with equities, bond-fund returns look bountiful

Bond funds are boring? No longer. Those investing in rock-solid, short-term U.S. government issues produced an average total return of 2.39% in the third quarter through Sept. 24--a stellar performance compared with the 19.6% loss by the average diversified equity fund. Returns at funds investing in long- and intermediate-term government paper did even better, racking up returns of 3.8% and 3.76% respectively, according to data compiled for BusinessWeek by Standard & Poor's, both part of The McGraw-Hill Companies.

Now the key question is how much potential for superior returns bonds have left. Investors certainly think there's plenty. After the Sept. 11 attack, they poured money into short-term Treasuries, pushing yields to lows not seen since the early 1990s and plumping the returns of funds specializing in such issues by three- quarters of a percentage point. It was a continuation of a love affair that has been running all year: In the first seven months of 2001, investors poured net new cash of $44.7 billion into bond funds--a complete reversal from the same period last year, when they yanked out $40.5 billion, according to the Investment Company Institute.

While investors favor the safety of very short-term government issues, which have the lowest risk of loss, many of the pros who live and breathe bonds are beginning to change their strategy and move into longer-dated issues. Their reasoning: The rally in short-term debt has about run its course. For instance, William H. Gross, doyen of the bond world, who manages $233 billion in bonds for PIMCO Investments, recently sold the bulk of his short-term government notes, buying medium-term governments instead. It's called moving up the yield curve. Short-term interest rates have fallen much faster than longer-term rates following the Federal Reserve's series of rate cuts, meaning that the yield curve, which plots the rates available on different maturities, has steepened--giving better running yields on longer bonds than short ones, as well as a chance for bigger capital gains if longer-term interest rates start to fall.

Even as some professionals move out of shorter-term bonds, others are moving in because they were in near-cash instruments such as money-market funds, which are now yielding a record low 2.55%. "With [money-market] yields getting down pretty low, we expect to be able to squeeze out at least another percentage point or two" by investing in short-term corporate- or government-bond funds, says Charles E. Foster, an independent financial planner with Blankenship & Foster in Del Mar, Calif. That's certainly been possible so far this year. Between Jan. 1 and Sept. 24, a $10,000 investment in the average short-term government bond on Jan. 1 would have returned $579 through Sept. 24, vs. $302 from the average taxable money-market fund.

Even managers who focus on intermediate-term bonds have been taking a longer view lately. Consider Rajiv Sobti, co-manager of the BlackRock Government Income Portfolio. Sobti's intermediate-bond fund is one of the best performers in the government-bond arena, sporting a 15% gain in the past year--far surpassing even the average equity fund. It's third-quarter 5.89% total return also ranks it among the best of breed. But Sobti believes that two-year U.S. Treasury notes, which recently yielded 2.5%, will eventually fall to between 2% and 2.25%, so he's tweaking the portfolio with longer-term securities. Lately, he has been buying mortgage-backed securities with five- and 10-year durations from Freddie Mac and Fannie Mae (FNM ).

DOMESTIC RISK. Diversification in turbulent markets is critical, even for bond investors. Plunking everything into U.S. Treasuries can expose investors to domestic risk. With that in mind, international options merit a look. Many have fared better than their U.S. counterparts: As a whole, the group returned 3.33%. The A-list includes the Strong International Bond fund, up 9.41% in the third quarter through Sept. 24; the Brinson Global Bond Fund, up 7.35%; and the Lord Abbett Global Income Fund, up 6.23%. While the managers of these funds mainly invest in foreign government debt, they have also gotten a boost from the currency appreciation.

If there is any appetite for risk among bond investors--or a penchant for contrarian thinking--they might consider dabbling in high-yield junk bonds. Jim Kelso, portfolio manager of the Morgan Keegan High Income Fund, sees "the best opportunities in high-yield in years," and investors could reap returns in six to nine months.

However safe bond funds may seem compared with equities, they're not static. Investors need to stay on top of fast-moving bond-market dynamics.

Corrections and Clarifications In ``The suddenly sexy...government bond'' (Finance, Oct. 8), the correct name of the T. Rowe Price fund on ``The bond fund leaders'' table is T. Rowe Price International Bond Fund.

By Geoffrey Smith in Boston

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