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MUTUAL FUND QUARTERLY REPORT

Bonds mostly in the red

The average fund still lost much less than the typical stock fund in the third quarter. But risks remain.

October 12, 2008|Tom Petruno | Times Staff Writer

Normally, losing 5% in a bond mutual fund in a quarter would be considered a terrible performance.

But with double-digit stock market losses so widespread in the three months ended Sept. 30, the bond market's red ink seemed much easier to bear.

That story line has continued in spades in the fourth quarter, just 12 days old. Many bond funds again are in the red, but far less so than stocks, which have been brutalized by relentless selling.

In both markets, the central issue remains investors' desperate desire to reduce risk and focus on safety of principal, amid severe worries about the financial system and economy.

For a few days at the end of the last quarter, even a classic risk-reduction move -- shifting savings to money market mutual funds -- appeared to be fraught with peril after a large money fund lost principal value on IOUs of bankrupt brokerage Lehman Bros. Holdings Inc.

The revelation triggered a run on many other funds, until the U.S. Treasury stepped in with a temporary insurance plan to guarantee money fund investors' principal. With the global credit crunch worsening, the last thing Wall Street needed was a sustained run on the $3.3-trillion money fund business.

The credit crunch also has had a direct effect on investors' perceptions of bond values, of course. Junk bonds, for example, have plunged in value because investors assume that it will only get more difficult for debt-heavy companies to fund themselves. That boosts the risk of default on junk issues.

Overall, though, the advantage bond funds have over stock funds in dicey periods like this is that the interest income bonds provide is a cushion against loss of principal value. That makes bonds a relative haven in a diversified investment portfolio.

Here's a look at how various bond fund categories fared in the third quarter:

Government bond funds

The government category was the only winner in the quarter, as investors worldwide hoarded Treasuries as a safety play.

The average fund that owns longer-term government bonds rose 1.4% in the three months through Sept. 30, according to Morningstar Inc. That's a "total return," meaning interest earnings plus or minus principal change.

The yield on the 30-year Treasury bond slid from 4.52% at the end of June to 4.31% at the end of September, boosting the value of older bonds issued at higher yields.

Funds that own intermediate-term and short-term government bonds also recorded positive returns in the quarter, although they were modest.

Still, last week's rebound in long-term Treasury yields was a reminder that it is possible to lose money even in government bond funds: If market rates rise, older bonds issued at lower yields are devalued.

With yields so relatively low on Treasuries now, some analysts warn that long-term returns on government bond funds could be disappointing. "You're buying a very expensive asset" at current prices, said Jeff Tjornehoj, a fund industry analyst at Lipper Inc.

Some money managers say government-backed mortgage debt, such as bonds backed by Ginnie Mae, are a much better investment than Treasuries.

"At current yields, we believe this sector represents some of the best value available for investors," investment strategists at money management giant BlackRock Inc. told clients in a report last week.

Corporate bond funds

This sector suffered sharp losses in the quarter as nervous investors shunned even the highest-quality corporate debt. That drove up market yields and drove down bond values.

Generally, the shorter the maturity, the smaller the loss on corporates in the three months -- which is the way it's supposed to work.

Morningstar's intermediate-term investment grade bond fund category lost 3.6% in the quarter, while the long-term investment grade category fell 7.2%. A loss on a bond fund means the decline in the fund's share price more than offset interest earnings.

Within the corporate bond sector, junk bond funds were slammed in the quarter, losing 8.2% on average. Things got worse last week as worries about the economic fallout from the credit crunch triggered another heavy wave of selling of junk securities.

Investors also have continued to dump bank loan funds, which buy pieces of corporate loans. Those funds slumped 6.8% in the quarter.

Analysts figured that default rates on junk bonds would rise as the economy weakened. But the scope of the credit crunch now has many on Wall Street fearful of the worst recession since the early 1980s, and expecting a much larger number of bond defaults than was estimated even a few months ago.

"The unprecedented crisis gripping the financial sector will magnify default risk, causing this cycle to be significantly deeper and more dispersed" across industries, analysts at Standard & Poor's warned in a recent report.

On Friday, the average yield on an index of 100 junk issues tracked by KDP Investment Advisors soared to a 17-year high of 15.62%, up from 10.85% in mid-September and 10.23% at the end of June.

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