Bonds: Is the Party Over?

If rates rise, big funds may get hit the hardest.

So, you finally got your act together and added some brand-name bond funds to your portfolio. Now all you have to do is sit back and enjoy those ballyhooed big returns. Right?

Wrong. The bond party may just be winding down. Sure, on Mar. 24 Treasuries reached their highest point in four months, as investors grew more skeptical about the likelihood of an economic rebound -- even if the Iraq war is resolved quickly. But the simple truth is that interest rates are now so low that they can't have much farther to fall. The chances are higher that interest rates will rise, says Standard & Poor's fixed-income analyst Gary Arne. "If you've just invested in a bond fund, you're ultimately going to take some hits."

Interest-rate risk isn't the only thing that bodes ill for bond investors. S&P reports that for corporate bonds, downgrades and defaults will outpace upgrades this year. So as managers of diversified funds hunt for higher yields, they'll be embracing more credit risk as well. "It's a name by name situation," says Lisa Black, manager of the TIAA-CREF Bond Plus Fund, a $370 million, multisector fund that's up 11% for the year ended Mar. 21, and is flat so far this year. "You still have the issues that come up and bite you." Black, who follows a conservative management style, has made limited new bets in higher-yielding debt, such as utility CenterPoint Energy (CNP ) and media companies Clear Channel Communications (CCU ) and Comcast (CMCSK ), which yield 6.95%, 4.63%, and 7.05%, respectively.

Taking on added risk hasn't paid off for a lot of bond managers of late. A year ago, many bond pros were arguing that the high-yield market was poised to take off because the yield gap with Treasuries was very wide by historical standards. It didn't. Meanwhile, the biggest bond funds weren't safe havens either. Large funds such as PIMCO Total Return, the Evergreen Core Bond Fund, and the Fidelity Investment Grade Bond Fund disappointed investors even when interest rates were falling and the bond bulls were on the rampage.

Many were nailed by blowups at investment-grade issuers, such as WorldCom. Last year, nearly every one of the 100 largest funds failed to keep up with the 10% gain in the Lehman Aggregate Bond Index, the benchmark for diversified funds, according to S&P. Even the Vanguard Total Bond Index, which is designed to track the market, fell short by 1.63%. "It's all about relative performance in the bond world, and last year was the worst on record" for the big funds, says Daniel Vandivort, who oversees $14 billion in fixed-income assets for Weiss, Peck & Greer in New York, an institutional money-management firm.

Without any major hiccups, the largest diversified bond funds are ahead of the Lehman index so far this year. But some observers expect another year of lackluster returns. "They are structurally so deficient that they will never, ever surpass what the market does," says Richard Ganz, money manager at Fixed Income Management Group. He maintains that managers can't be opportunistic or creative enough to beat the market. And many have strict mandates about the average maturity of the bonds they hold.

To add insult to injury, some funds have raised their fees to investors. USAA, for instance, has lifted charges for at least six of its bond funds by 20% or more since 2001 to as high as 1.00% for its USAA High Yield Opportunities fund, according to Morningstar.

The best way to manage risk is by buying lots of different issues. That's been a big theme for bond-fund manager David Albrycht. He oversees $3 billion in bonds for Phoenix Investment Partners, including the $261 million Phoenix Goodwin Multi-Sector Short-Term Bond fund, which has returned an annualized 6% for the past decade. He has close to 60 names in his stable of corporate investment-grade bonds, including AOL Time Warner (AOL ), Clear Channel, and Cox Communications (COX ). He's added high-yield investments, such as Allied Waste Industries (AW ), Nextel Communications (NXTL ), and El Paso Energy Partners (EP ) -- but spread out his risk among 44 different issuers.

As defaults and bankruptcies wane, the more adventurous managers will be rewarded in their quest for yield. Meanwhile, don't think just because you're invested in a bond fund that returns are a given. All investments carry risk -- even boring old bond funds.

By Mara Der Hovanesian

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