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Rate Hikes Hobble Bonds

The first quarter was `more of the same,' but strategists see light ahead if the Fed ends its credit-tightening effort.

April 08, 2006|Josh Friedman | Times Staff Writer

It was a new year -- but an old result -- for bond fund investors.

Bond mutual funds endured a lackluster first quarter as the Federal Reserve, still fearful that a tight labor market and steep energy prices might spark higher inflation, extended the campaign of interest rate hikes it launched in June 2004.

After the bond market's worst three-year stretch since the early 1980s, the first quarter amounted to "more of the same," said Bill Hornbarger, fixed-income strategist at brokerage A.G. Edwards & Sons Inc. in St. Louis.

"The bond market is really struggling under a Fed that has very methodically and meticulously raised interest rates at 15 consecutive meetings," he said. As yields have risen, bond prices have fallen, undercutting total returns.

Government bond mutual funds tracked by Morningstar Inc. produced an average loss of 0.8% in the quarter, while the corporate bond category eked out a positive total return of 0.5%. Total return is interest income plus or minus a fund's net change in principal value.

For the three years ended in March, government bond funds generated an average annualized return of 1.9%. For corporate bond funds, the average return was 5% a year. By contrast, the average U.S. stock fund soared 20.8% a year in the period.

Bond investors could see better performance this year if the Fed halts its rate hikes -- and particularly, if central bankers shift direction and start cutting interest rates, which could boost bond values.

The Fed has lifted its target short-term lending rate to 4.75% from 1% through a series of quarter-point hikes, and it is widely expected to raise the rate to 5% at its next meeting May 10.

The target rate has neared or reached the point where many strategists see monetary policy as "neutral," no longer "accommodative" to economic growth. Meanwhile, the U.S. housing market is showing evidence of cooling.

Those factors could spur the Fed to stop its credit-tightening campaign after the May meeting if policymakers change their focus from the risk of inflation to the risk of an economic slowdown.

That would be good news for investors in bond funds such as the $94-billion Pimco Total Return fund, which lost 0.5% in the first quarter on its institutional-class shares.

"The beauty of this for the bond market is that the Fed is essentially done," said Mark Kiesel, portfolio manager at Pacific Investment Management Co. in Newport Beach, which runs the Pimco funds.

Typically, the Fed pauses for six to nine months after a series of rate hikes before loosening credit, Kiesel said, which means rate cuts could come by early 2007 if indeed next month marks the last increase.

But bond yields often fall in advance of such a move, which means bond fund total returns could pick up this year, he said.

The Fed isn't tipping its hand. Bond strategists caution that an economic surprise such as an unemployment rate that slips below the recent low of 4.7% -- recorded in January and again in March -- could stoke inflation fears and prompt further interest rate hikes. In a tight labor market, wage increases can fuel inflation.

The March payroll data sparked a bond market sell-off Friday as investors focused on the unemployment rate rather than on hourly wage growth, which was tamer than expected.

Even if the Fed continues tightening credit until its target rate hits 5.5%, as some analysts expect, bond strategists say the market looks more attractive now that yields have risen sharply from the lows of recent years. The 10-year Treasury note yield was 4.98% on Friday, the highest since 2002.

"I think we'll end the year with positive returns," said Mary Miller, director of fixed income at T. Rowe Price Group Inc. in Baltimore. "Yields are going to grind higher, but as we move through the year, you will get the benefit of bond income and, ultimately, more stable interest rates."

Even if bond funds post modest returns this year, they make sense as a portion of most investor portfolios, Miller said, because they can balance out the volatility of stock funds.

Not all bond fund categories have been in the red, of course.

High-yield, or "junk," bond funds, which invest in the riskiest corporate debt in hopes of earning high returns, and emerging market bond funds were two standout categories in the first quarter, returning 2.6% and 2.4%, respectively.

Some strategists urge caution on those sectors, however. They say the tide could swing back to less risky segments of the bond market, such as two-, five- and 10-year Treasuries, whose yields are more attractive thanks to their recent jump.

"The time to buy high-yield is at the bottom of an economic cycle, and we're probably closer to the top right now," Hornbarger said.

For California investors in high tax brackets, tax-free municipal bond funds may be enticing, Miller said.

That's because current muni yields compare favorably with Treasury yields on a tax-adjusted basis, she said. California residents don't pay federal or state income tax on California muni interest.

The average 12-month yield on long-term California muni bond funds is 4%, according to Morningstar. That compares with a yield of 4.9% on the average taxable long-term investment-grade bond fund.

For an investor in the 35% combined federal and state tax bracket, a 4% tax-free yield is equivalent to a taxable yield of 6.1% -- well above yields on most investment-grade taxable bond funds.

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