Risk and reward usually go hand in hand. But bond mutual fund investors learned last year that sometimes you get rewarded for playing it safe.
For the second year in a row, long-term government bond fund investors earned double-digit returns on their money, ending the year up an average of 14.3%, according to Chicago fund tracker Morningstar Inc.
That was more than three times the total returns (interest income plus or minus any change in principal) of the average fund that invests in corporate bonds, debt which is considered riskier because individual companies occasionally default on their debt.
And the government bond return was higher than the total returns for the average domestic stock fund, which was up 13.7% for the year.
"I wouldn't have suspected that at all," said Loomis Sayles & Co. Managing Director Kent Newmark, who oversees the firm's fixed-income assets.
To be sure, government bond fund returns cooled in the fourth quarter as investors began to finally tiptoe back into riskier sectors, such as high-yield funds, which invest in riskier junk bonds, and emerging-market debt funds.
Indeed, unusually wide spreads between the long bond and riskier sectors, which mushroomed in the third quarter, did begin to narrow a bit in the fourth, notes Ned Notzon, a managing director at T. Rowe Price Associates. And in the fourth quarter, emerging-market bond funds surged 12.3% while junk funds gained 2.4%.
Still, both categories finished 1998 underwater. Despite generous yields of 11.3% and 9.2%, respectively, the average emerging-market bond fund was down 24.6% in 1998; the average junk bond fund lost 1.2%.
This proved, once again, that when it comes to bond fund investing, one needs to consider total return, not just income.
So what drove government bond funds' impressive performance?
As is always the case, analysts say, fear and greed. Oh, and Federal Reserve Chairman Alan Greenspan.
As the global financial crisis unfolded in the third quarter of 1998, investors bolted for the safest haven they could find. This "flight to quality" sent money pouring into long-term government bond funds, since these portfolios invest in debt that's backed by the full faith and credit of Uncle Sam.
The demand for U.S. bonds, low inflation and the prospect of U.S. surpluses reducing the amount of Treasury debt all pushed U.S. rates lower--and thus increased the value of existing bonds.
Other investors spotted this trend and poured even more money into the sector to chase returns, said Greg Schultz, principal at Asset Allocation Advisors in Walnut Creek, Calif.
The Fed's move to push interest rates down three times in 1998, starting in late September, certainly helped.
A fixed-rate bond's price moves in the opposite direction of market interest rates. When rates rise, the price of older bonds that carry lower fixed yields falls. But when market rates fall, older bonds rise in value because their yields are better than what investors can find in new bonds.
As a rule, the "further out" bond investors go in terms of maturities--in other words, the more risk they take by locking their money away for years--the more they stand to benefit when rates fall. Conversely, should rates rise, long bond holders tend to suffer more.
"It did pay to be long in Treasuries," Newmark noted.
Indeed, while the average long-term government bond returned 0.8% for the fourth quarter and 14.3% for the year, the average intermediate-term government bond fund (these tend to hold bonds that mature in seven to 15 years) was flat for the quarter and gained 7.3% for the year.
The average short-term government bond fund was up 0.4% for the quarter and 6.2% for the year.
At the same time, however, it did not pay to take on any additional risk in the corporate bond sector, either by buying lower-credit-quality bonds or longer-term debt, which compensate investors with higher yields.
While the average intermediate-term, investment-grade corporate bond fund delivered total returns of 0.2% in the fourth quarter to finish the year up 7.5%, the typical long-term, investment-grade corporate bond fund was up 0.8% for the quarter and only 6.3% for the year.
With heightened fears of a global recession, long-term corporate bond investors in 1998 decided that there was too much risk in holding long-term debt.
"With fears of a global meltdown came a tremendous amount of concern that a number of U.S companies would make less money, deteriorating their credit quality," Newmark said.
Fears of a recession did not deter fund investors from plowing money into tax-free municipal bond portfolios toward the end of the year.
Investors put a net $14 billion into muni bond funds in 1998 (through November), 17 times 1997's inflows, according to figures from the Investment Company Institute, the fund industry's chief trade group.
"People finally focused on the incredible values in muni bonds," said Reid Smith, co-manager of the Vanguard California Tax-Free Insured Long-Term fund.