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Hopes for Bonds High -- Again

After suffering for two years as interest rate hikes devalued their holdings, investors are looking for an end to the Fed's credit tightening.

July 11, 2006|Tom Petruno | Times Staff Writer

Wall Street continued to underestimate the Federal Reserve in the second quarter, with predictable results for the bond market: Returns on most bond mutual funds were negative or barely positive -- although they held up better than most stock fund categories.

As the new quarter begins, hopes again are high that the central bank is nearly done raising short-term interest rates, which could allow longer-term interest rates to stop rising as well.

That would be welcome relief for bond fund investors. For the last two years, rising market interest rates have devalued holdings of older fixed-rate bonds in funds' portfolios.

"We're bullish on bonds -- long bonds," declared David Rosenberg, Merrill Lynch & Co.'s chief North American economist, in a report to clients Friday.

He thinks the Fed already has gone too far in tightening credit, and ought to stop soon.

Another major brokerage, Goldman, Sachs & Co., also is telling clients that "enough's enough" with rising interest rates. A further Fed increase "is not warranted," says Jan Hatzius, one of Goldman's top economists.

But plenty of people on Wall Street had the same view for much of 2005 and in the first half of this year, and they were dead wrong. As the economy continued to grow at a healthy pace and inflation pressures increased, the Fed has raised its benchmark short-term rate 17 times since mid-2004, most recently from 5% to 5.25% on June 29.

Rising short-term rates pushed up longer-term interest rates as well in the second quarter, driving the yield on the bellwether 10-year Treasury note from 4.85% to 5.14% in the period.

One result: Most mutual funds that own intermediate-term or long-term bonds had negative total returns in the quarter. The declining principal value of the funds' bonds more than offset the interest earned. Total return is interest income plus or minus principal change.

The average fund that owns U.S. government bonds had a 0.1% negative total return in the three months ended June 30, according to Morningstar Inc.

The average corporate bond fund just broke even in the period.

The star sector of the last few years -- emerging-market debt funds, which own bonds of up-and-coming economies such as Russia and Brazil -- was the quarter's worst performer, losing 2.5%, on average. That reflected investors' sudden aversion to riskier assets, on fears that credit tightening by the Fed and other central banks might halt the global economic expansion.

Still, bond funds held up better than most stock funds in the quarter, a reminder that fixed-income securities can help damp volatility in a diversified portfolio. The average domestic stock fund fell 3.4% in the three months.

World income funds, which typically have a large chunk of their assets in high-quality foreign bonds, were the quarter's best bond sector, up 1.6% on average. They were helped as the euro and other currencies strengthened against the dollar in the period, boosting the value of foreign bonds when translated into dollars.

Another winner in the quarter: bank loan funds, which invest in high-yielding loans packaged by banks. They gained an average of 1% in the period.

The difficult choice now for many income-oriented investors: With short-term interest rates near or above longer-term rates (depending on the type of security), is it smarter to just stay in money-market funds or Treasury bills instead of taking a chance on bonds?

The average annualized yield on taxable money market mutual funds is 4.66%, according to ImoneyNet Inc. of Westborough, Mass. That yield is almost certain to continue rising in the next few weeks, reflecting the Fed's late-June rate increase.

New six-month Treasury bills Monday paid an annualized yield of 5.31%. By contrast, the yield on the 10-year Treasury note was 5.13% as of Monday.

Investment pros who advise buying bonds believe that the economy is slowing enough to persuade the Fed to stop tightening credit, and that rates soon will be headed down.

If that's correct, falling market interest rates would boost the value of older bonds issued at more attractive fixed yields. So in addition to earning interest income, a bond fund investor might enjoy a modest capital gain if the principal value of the portfolio increased.

That's Goldman Sachs' scenario. The firm believes the Fed will cut its key rate to 5% by the end of the first quarter of 2007. Because the bond market usually anticipates Fed moves, Goldman expects the 10-year Treasury note yield to be at 4.75% by the end of this year.

But a weaker economy could cause other problems for bond owners. Those who own lower-quality securities, such as corporate junk bonds, could be hurt if more companies have trouble paying their bills. That could lead to a jump in bond defaults, devaluing lower-quality issues.

What's more, even if the Fed stops raising rates, many foreign central banks appear poised to continue tightening credit. That could keep U.S. rates from falling, and cause trouble for foreign bonds.

Meanwhile, some analysts believe that Wall Street again is underestimating the U.S. economy and the Fed.

Michael Darda, an economist at investment firm MKM Partners in Greenwich, Conn., predicted that the economy would be stronger than expected in the second half, also keeping upward pressure on inflation. That means the Fed will have to continue raising its benchmark rate, and will end up "closer to 6% than 5%" by year's end, Darda said.

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