Bond Funds: Don't Expect a Full-Course Meal

The portions are smaller, but some still hold great potential. Here's our guide to the best:

What are bond investors to do? After feasting on a three-year bull market, they may have to settle for smaller rations. And whether or not the U.S. economy is on the verge of a comeback and the Federal Reserve responds by nudging up interest rates is the least of the worries. The market's most serious threat comes from the Bush Administration's proposal to eliminate most of the taxes that individuals pay on dividends. That could make stocks serious competition for taxable government and corporate bonds--and even tax-free municipal bonds.

There's more. The looming war with Iraq may frighten off bond investors until the confrontation is resolved--and that could take months. The costs of a war and a tax cut will exacerbate a ballooning federal budget deficit, which by some estimates could surpass $300 billion by next year. Some analysts argue that the deficit is still too small to drive bond yields sharply higher, but others aren't so sure. What's more, the states are facing massive deficits of their own, and this may drive up muni yields as governors borrow to comply with balanced-budget laws.

The bottom line: Interest rates on fixed-income securities could climb sooner than economists and money managers anticipate--cutting bond prices faster than investors expect. Roger Early, chief investment officer for fixed income at Turner Investment Partners in Berwyn, Pa., which manages $7 billion, foresees "a big bear market" for Treasuries, with yields on 10-year bonds soaring to 5% this year, up from 4% now. If he's right, those bonds could fall more than 7% in price. "Treasuries have probably had their day," adds Early.

For those investors who have plunked their whole bond portfolios into safe U.S. governments and munis, it's probably time to rethink their strategy. The 18th edition of the BusinessWeek Mutual Fund Scoreboard is a good place to start. After researching data prepared by Standard & Poor's, we've identified an elite group of 102 bond funds whose managers have produced the highest returns with the least amount of risk over the last five years. These funds get our A rating. We also rate funds against their peers in each specific slice of the bond market.

The Bond Scoreboard, with full details of 202 taxable funds and 146 tax-exempt funds, starts on page 88. You'll find the complete list of 1,576 funds in our database at The online version is updated monthly and has tools to screen funds by expenses, average maturity, or fund size.

For the third year in a row, corporate-bond funds beat stocks by a mile, returning a solid 7% in 2002, vs. a loss of 23% for the average U.S. stock fund, according to S&P. Out of about 900 funds that specialize in investment-grade bonds, only 18 posted losses. The corporate-bond managers who are A-rated have a lot in common: They stick to conservative strategies, keep a high-quality portfolio of diversified names, and rarely put too much money into a single issuer. Many are dogged in their credit research, relying on in-house talent to sniff out potential trouble.

One such group is Payden & Rygel, which manages $47 billion in stock and bond funds. The Los Angeles firm has two funds on this year's A-list: Payden Core Bond and Payden Global Fixed Income. Manager Brian Matthews of the domestic fund says his research team--and a strict discipline that dictates when to sell a bond--got him out of hot water last year when WorldCom Inc., investment-grade issuers at the time, started imploding. Currently, his fund is invested in the debt of companies with stable credit, such as Target (TGT ), Lockheed Martin (LMT ), Wells Fargo (WFC ), and Gannett (GCI ). "We're very cautious about corporate profits and whether companies can keep up with debt already on the books," he says.

Still, some top-rated managers are willing to take a chance. High-yield bond funds rebounded in the fourth quarter--a sign of good things to come, say some money managers. Funds that invest in junk bonds returned 6.2% on average in that three-month period, erasing most of their losses earlier in the year. Money managers say that if the U.S. economy recovers and global worries subside, the high-yield market could build on that recent momentum and enjoy a strong performance in the next few years. The heightened attention to a company's liquidity and creditworthiness is another big plus because it reduces risk, says Robert F. Auwaerter, manager of the A-rated $3.5 billion Vanguard Intermediate Term Corporate Bond Fund, which buys investment-grade paper. "Default risk hasn't been all wrung out," he says. "But the level of scrutiny is at an all-time high. That will help the whole corporate-bond market."

Since investing in junk is more like buying stocks than bonds, it's no surprise that most A-rated managers shy away from relying too heavily on high-yield issues. Telecom bonds in particular bounced up a dramatic 25% on average since November, but Turner Investments' Early, for example, won't bite. He's leaning toward cyclical companies, such as heavy-equipment maker Briggs & Stratton and propane-gas sellers Ferrellgas Partners, that are likely to benefit in a recovery.

Like junk-bond funds, the performance of funds that invest in emerging markets can be extremely volatile from year to year. But if investors are in for the long haul, the best funds can make the ride well worth the trouble. Many of them, such as the PIMCO Emerging Market Bond Fund and the GMO Emerging Country Debt Fund III, don't make outsize bets on any particular country. The GMO fund plunged 30% in 1998 at the height of the Asian financial meltdown, but it has still averaged double-digit returns since its 1994 inception. A-rated co-manager Tom Cooper doesn't visit the countries that he invests in because he hates to travel. Instead, he crunches data to find cheap bonds that yield more than similar ones from the same country. "We buy and hope they pay," he says. He invests mostly in the world's largest issuers--Brazil, Mexico, and Russia--with a smattering of smaller countries such as the Dominican Republic.

Closer to home, munis have also been on a roll. Collectively, funds investing in more than one state posted an average gain of 9%--one of the best results of any sector. A low default rate, high credit quality (about half the bonds held in muni funds are AAA-rated), and yields that are at least comparable with or better than those of U.S. Treasuries helped boost performance, according to S&P analysts.

As state and local governments tackle their huge budget deficits over the next couple of years, it will be even more important for investors to stick with A-rated managers who did well in both the boom and the bust. One such is Paul A. Toft, manager of Victory Capital Management Inc.'s $85 million Victory National Muni Fund since 1994. "There are those who try to make big interest-rate bets, or buy speculative credit quality and hope they hit a home run," says Toft, who has earned an annual 7.6% return over the last five years. "That's not what I do." One of his strategies is to buy debt in states such as Montana, Idaho, and Arizona where there's high demand for bonds from locals, but limited supply.

Like most other successful managers, Toft's aversion to risk earns him high grades. Some have conservatism built into their investing mandates. Several A-rated funds in American Century's lineup fit that bill, even though they racked up outsized returns, from 27% to 37%, last year. Five of the company's Target Maturity Series funds were among the top 10 performers among all bond funds. But the funds--which invest in zero-coupon U.S. Treasury securities and hold them until maturity--can have wild swings from year to year because the investments are very sensitive to interest-rate changes. "We've designed these for the buy-and-hold investor," says lead manager Jeremy Fletcher. Investors holding the fund to maturity should expect to earn on average 5% a year, he says.

John Brynjolfsson, who manages the $6.4 billion PIMCO Real Return Bond fund, is in the same conservative camp. The bulk of the fund's assets are in TIPS, or Treasury Inflation-Protected Securities. The principal or par amount of the bond is indexed to inflation; as it rises, the coupon payments do, too, so investors can't lose purchasing power. His A-rated fund, which has earned 9% a year on average for the last five, appeals to investors "looking for something they can bank on," he says. "There are still land mines out there."

Land mines aren't what investors envision when they think of investing in bond funds. It's all the more reason to read our Scoreboard and survey the suddenly perilous lay of the land.

By Mara Der Hovanesian in New York

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