Bonds Prove Their 'Cushion' Value as Stocks Tumble

For too many investors over the last few years, asset allocation meant owning some Yahoo, some Cisco Systems, a little Microsoft and the dot-com of the month.

Bonds? Those were for old fogies.

But bond mutual funds trounced stock funds in the first quarter, and over the last year some bond fund categories have produced double-digit total returns, meaning interest earned plus gain in principal value.

At the very least, owning some bonds was a way for investors to offset serious losses in their stock portfolios.

In part, bonds have won because stocks have lost: As share prices have tumbled, many investors have sought refuge in Treasury securities. Amid strong demand, yields on new bonds have fallen--boosting the value of older, higher-paying bonds.

Treasury yields and yields on other high-quality bonds, such as corporate issues and tax-free municipal issues, also have dropped because the Federal Reserve has cut interest rates as the economy has slowed.

Nearly all bond fund categories showed gains in the first quarter:

* Long-term investment-grade funds, which own high-quality corporate issues, had an average total return of 3% in the quarter, according to Morningstar Inc. Over the last year, the funds are up 9.9%, on average.

* Municipal bond funds overall gained about 2% in the quarter and are up between 7% and 10% over the last year in total return.

* Long-term government bond funds rose 1.8% in the quarter and are up 12.4% over the last year.

* Corporate junk bond funds rebounded in the first quarter. Those funds gained 3.6%, on average after losing 9.4% in 2000. But the junk sector remains troubled: If the economy continues to slow, experts say, more high-risk bonds are likely to go into default--meaning the companies that issued them won't be able to pay interest owed.

Even high-quality bonds aren't without risk, analysts note. If the economy begins to rebound later this year and market interest rates rise, bonds could produce low or negative returns. That's the nature of the investment: You're at the mercy of whatever happens with market rates.

What's more, investors buying Treasury bonds today are getting the lowest yields in at least two years. That increases your risk if rates suddenly whipsaw.

Still, even in bad years, bonds generally don't post anywhere near the kind of losses that stocks can suffer.