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And the Laggards Are ...

Bond funds, beaten by cash in 2005, are a tough sell with unattractive yields. Their '06 return will depend on the economy and the Fed.

January 10, 2006|Tom Petruno | Times Staff Writer

The typical money market mutual fund generated a higher return in 2005 than most bond funds, and this year is shaping up to be a tough test for bonds as well.

The basic problem for bond funds is that short-term interest rates are at their highest levels in nearly five years, and are close to -- and in some cases above -- what long-term bonds pay.

That's making it harder for investors to justify the risks in owning bond funds.

In 2005, the average government bond fund produced a total return of 1.9%, according to Morningstar Inc. The average corporate fund's total return was 2%. Total return is interest income plus or minus a fund's net change in principal value.

Both the government and corporate fund averages trailed the 2.7% yield earned by the average money market fund for the year, according to IMoneyNet Inc.

Many bond funds paid higher interest income for the year than did money funds, but rising market interest rates depressed the value of older, lower-yielding bonds in fund portfolios. That eroded the principal values of many bond funds.

There were exceptions. Emerging-market bond funds had another good year, producing an average total return of 11.7%. Besides paying high yields, the funds got a boost as the dollar fell in value against currencies of some major emerging-market bond issuers, including Brazil and Mexico.

But for an investor contemplating whether to hold or buy a bond fund today, a few numbers show why many bond sectors are a difficult sell:

The current annualized yield on the Vanguard Intermediate-Term Treasury fund, a popular low-cost fund, is about 4.32%. By contrast, an investor could earn an annualized 4.40% on six-month Treasury bills bought directly from Uncle Sam. And the current yield on the average money market fund is 3.6%, and rising.

Short-term interest rates have surged since mid-2004 as the Federal Reserve has raised its benchmark rate from 1% to 4.25%. But the Fed has been signaling over the last month that it is probably near the end of its credit-tightening campaign.

If the Fed is nearly done, there are two possible scenarios for interest rates:

* The Fed holds short-term rates near current levels for an extended period, perhaps all of 2006. If that's the case, money market funds and other shorter-term cash accounts could continue to provide stiff competition for many bond funds.

Tad Rivelle, chief investment officer at Metropolitan West Asset Management in Los Angeles, expects that the economy will continue to grow this year and that bonds will produce "reasonable but unspectacular returns."

* The Fed begins cutting short-term rates, either in the spring or in the second half of the year. Under this scenario, yields on long-term Treasury bonds and other high-quality issues could fall as well. Bond funds that own those kinds of securities could do well because they would have locked in higher yields.

But for the Fed to start easing credit, the assumption is that policymakers would be responding to a softening economy. That could mean trouble for corporate junk bond funds.

Junk bonds are those rated below investment grade. They pay above-average yields because the companies that issue them are relatively risky; they may have heavy debt loads or are in businesses vulnerable to downturns in a weaker economy.

The junk market got a scare last spring, as Wall Street began to focus on the possibility that General Motors Corp. could file for bankruptcy protection because of its financial woes. Some investors dumped junk bonds, driving their prices down; in turn, investors demanded higher yields on newly issued junk bonds to compensate for what they perceived as a rising risk of defaults.

The result: The average total return on junk funds was a disappointing 2.5% last year, as declining principal values offset most of the interest earned.

Paul McCulley, an economist and portfolio manager at bond fund giant Pacific Investment Management Co., or Pimco, in Newport Beach, is in the camp that believes that the economy will slow this year. That makes Pimco cautious about corporate bonds, particularly junk issues, he said.

"The clearest risk is the potential for a rising default rate in the high-yield bond arena," McCulley said.

For investors who need the income that bonds generate, and who can weather swings in principal value, two perennial bits of advice may be especially useful this year:

* Consider municipal bond funds. Muni bond funds held up relatively well in 2005 compared with other bond sectors. The average long-term California muni fund produced a total return of 3.8%, according to Morningstar.

Because California residents don't pay federal or state income tax on California muni interest, the true return on the funds was higher than the stated figure, depending on an investor's tax bracket.

Bond investors should look at their tax brackets and calculate whether they could earn a better rate of return on munis than on corporate or Treasury funds.

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