That Old Bond Magic May Not Last

Nevertheless, some bond funds still hold great potential. Here's our guide to the best

Bonds have beaten stocks hands down for two years running. Thank a lousy economy and a Federal Reserve Board on a tear to cut short-term interest rates. The average bond has soared 10% a year since 1999, while equities have tumbled by an equal amount, resulting in some of the best relative returns for bonds--from rock-solid U.S. Treasuries to emerging-market debt--in years.

Taxable bond funds flew off the shelf last year: An inflow of $76.5 billion through November was their biggest ever, while net inflows into equity mutual funds were on track to be the smallest since 1990. But before you plunge any deeper, be aware that many pros consider an encore unlikely. "The powerful excess returns of bonds vs. stocks is yesterday's news," says J. Thomas Madden, Federated Investors' chief investment officer in Pittsburgh, Pa.

Indeed, holders of longer-term U.S. Treasury bonds could get whipsawed. Even a modest recovery may prompt the Fed to go into reverse and tighten short-term rates by as much as 1.5 percentage points by yearend, says Paul Lefurgey, manager of $4.8 billion in fixed-income products for Duff & Phelps Investment Management in Chicago. That will send bonds, which fall when interest rates rise, tumbling. If the yield on a 10-year Treasury jumps by half a percentage point from about 5% now, it will lose about 10% of its market value. "If you are loading up your portfolio with hyper-quality issues anticipating a need for being risk-averse, you're overdoing it," warns Keith F. Karlawish, director of fixed income for BB&T Asset Management.

Does that mean you should dump your bond holdings or forget about adding new ones? Heavens, no. Rather, it's time to temper expectations, vary the mix, and seek higher yields. The key is finding funds that hold the greatest potential for long-term gains. The best opportunities, say the pros, lie in investment-grade corporate debt and the highest-quality junk debt, which pays 2.2 and 9.8 percentage points respectively above Treasuries with the same maturity. The premiums are likely to narrow sharply as the economy improves. Moreover, the 5.8 percentage points of extra yield that emerging-market debt pays looks enticing, too. Bond guru William H. Gross, manager of PIMCO Total Return, says there's plenty of money to be made. He's been buying corporate bonds, mortgage securities, and emerging-market debt, figuring he can get an 8% total return on his money. "With 1.5% inflation and a 5% stock market world," he says. "They look quite sexy."

However, with most of the easy money already wrung out of the bond market, it's going to take nifty footwork to beat the averages. Where to start? Here, with the 17th edition of the BusinessWeek Mutual Fund Scoreboard, prepared by Standard & Poor's, which is also owned by The McGraw-Hill Companies.

The crème-de-la-crème of bond funds get our A rating by producing the highest returns for the least risk over the past five years. It's an exclusive bunch: Only 101 out of 1,656 funds meet the criteria this year. We've also rated funds against their peers in each category. Starting on page 86, you'll find the Scoreboard, with 190 taxable funds and 143 tax-exempt funds. Our Web site at gives those and 1,323 more funds in an interactive Scoreboard version. There you'll find tools to screen funds by sales charges and expenses, average maturity, or fund size. The Scoreboard covers the whole gamut of funds. At one extreme are the emerging-market bond funds--a group boasting the best three-year and 2001 returns. As the global economy improves, stable emerging markets with ties to major industrialized nations, such as Mexico and Poland, will rebound first. Yet these funds are not for the faint of heart: None rates higher than B+ because of the sector's erratic year-to-year returns.

Some of the biggest bang for the buck has come from corporate bond funds over the past five years. That trend, once the economy picks up, is expected to continue. It's not going to move in a straight line, however. Remember, the consensus wrongly assumed at this time last year that the economy would respond to the Fed's aggressive easing in 2000. So investors should "tip-toe in rather than dive head-first," says Colin J. Lundgren, senior fixed-income manager of $7 billion in bond funds at American Express Asset Management Group Inc.

Bond-fund managers themselves are leaning toward A-rated corporate bonds, which still qualify as investment grade, albeit at a low level. And there's a fresh supply of corporate bonds on the market. Companies such as DaimlerChrysler (DCX ) and Duke Energy Corp. (DUK ) have issued new debt to lure investors looking for alternatives to low-yielding government bonds. Nimble managers are now sniffing around for debt from cyclical companies, says Duff & Phelps's Lefurgey, including auto companies, industrial outfits, and retailers that should benefit first from an economic upswing. Some of the best specialists in the sector include Fidelity Intermediate Bond, MFS Limited Maturity, and Wachovia Short-Term Fixed-Income funds. The A-rated Fidelity fund, for example, gained 8.4% last year by feasting on lower-rated corporate bonds--even in an iffy climate. The fund ranks at the top of the five- and 10-year performance charts.

With Corporate America still struggling, some investors may be leery about defaults. But while defaults are nearing record levels, they appear to be headed for a plateau. The number of corporate issuers defaulting last year soared to 211, representing $115.4 billion of debt, up from 132 issuers and $42.3 billion in 2000, according to S&P. Those defaults, a lagging indicator of economic health, are expected to climb until summer, then "improve gradually," says Diane Vazza, S&P's head of global fixed-income research. "We're bottoming in this quarter." Furthermore, the extra 10 percentage points of yield on junk bonds compared with Treasuries is historically high and double where it was a couple of years ago. "The best investments might now be at their darkest hour," says Vazza.

Picking an A-rated junk-bond fund from BusinessWeek's list increases the chances that you'll get a steady-as-she-goes manager, not one who overdoses on risk in pursuit of high returns. You won't find managers who piled heavily and recklessly into telecom companies: The telecom slice of the Merrill Lynch High Yield Master Index, a guide to overall junk-bond performance, had the worst results last year, down 33%. And prospects--indicated by the 30% yields that many are paying now--aren't too hot, either. "There's a lot of opportunity, [but] if you don't know what you're doing, it's very, very risky," says Amy Falls, Global Fixed-Income Strategist for Morgan Stanley. Funds such as the Merrill Lynch Bond High Income, Invesco High Yield and AIM High Yield funds get flunking grades in the Scoreboard, mostly for overweighting telecoms.

There are, however, high-yield fund managers who have deftly sidestepped the blowups. Consider the A-rated Columbia High-Yield Fund. The fund maintains an average credit rating of BB--just one level below investment grade. Managers Jeffrey L. Rippey and Kurt M. Havnaer have profited from defensive health-care companies, up 17% last year. Their winners included bonds issued by Tenet Healthcare Corp. (THC ) and Health Care Property Investors Inc. (HCP ), a real estate investment trust. They figure that the market is purging itself of poor-credit qualities, which bodes well for high-yield companies that they invest in. Rippey and Havnaer are even tempted these days to venture into slightly riskier terrain: B-rated American Axle & Manufacturing Holdings Inc. (AXL ) and Iron Mountain Inc. (IRM ) "We've sold some of our most defensive names," says Havnaer. "But we're still buying companies that are getting upgraded in credit quality."

Even short-duration bond funds are taking on additional risk. Sandy R. Rufenacht, portfolio manager for the A-rated Janus Short-Term Bond Fund, is turbocharging his blue-chip offering with some lower-rated paper. At first blush, you'll see that Rufenacht favors top-shelf debt from General Electric, IBM, and Wal-Mart Stores. "I don't get too fancy, and I try to pay a lot of attention to what the economy is doing," he says. Rufenacht locks in his yields with debt that has a three-year duration, which in a declining interest-rate environment makes good sense. But Rufenacht--who also doubles as Janus' High-Yield Fund manager--juices the returns on his short fund with high-yield debt that's on the verge of being repaid. Currently 0.45% of the portfolio is in two-year, BB-rated bonds issued by Apple Computer Inc. (AAPL ), yielding 6.5%. Another tiny position is in Tritel Communications Inc., a wireless cell-phone provider that will pay a 10.4% coupon, until its new acquirer, AT&T (T ), buys back the bonds.

Mutual funds that invest in bonds aren't likely to be the show-stopper they've been recently. But at least, with the help of this Scoreboard issue, you're less likely to buy a flop.

Corrections and Clarifications In "That old bond magic may not last" (Mutual Fund Scoreboard, Feb. 4), the market-value loss resulting from a 5% 10-year Treasury bond's yield rising to 5.5% should have been stated as a little under 4%, rather than 10%. Only a zero-coupon bond would have suffered a 10% loss. Also, the highest-quality junk debt pays about 4 percentage points, not 9.8 percentage points, above Treasuries.

By Mara Der Hovanesian in New York

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