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Junk bonds were trashed, U.S. bonds were treasured in '08

January 11, 2009|Josh Friedman

For bond funds, 2008 was spectacular. And disastrous.

A 5.2% gain last year in a Barclays Capital index tracking the value of bonds of all kinds obscured the fact that performance in the fixed-income world was all over the map.

Investors facing an unpredictable economy dumped corporate and municipal bonds -- as well as stocks -- in favor of the perceived safety of U.S. government securities, driving up their prices while driving down their yields.

Funds specializing in long-term Treasuries posted total returns (interest earnings plus or minus any change in market value) averaging 28%, according to Morningstar, offering just about the only big money to be made anywhere in the investment world last year.

But the same aversion to risk left most of the bond sector in the red, sticking many investors with double-digit losses in the supposedly conservative part of their portfolios.

Many fixed-income funds fell 20% or more, with much of the damage coming in the fourth quarter.

"People were not even remotely prepared for the level of volatility we experienced," said Eric Jacobson, an analyst at Morningstar Inc.

Short- and intermediate-term government funds gained 4.7% for the year, on average, but junk-bond funds tumbled 26% and several other categories, including some municipal bond sectors, dropped 10% or more.

The fact that all bond sectors still outperformed U.S. stock funds, which averaged a 36% loss in 2008, was little comfort.

"Fixed-income investors are not used to seeing these kinds of losses," said Marilyn Cohen, president of Envision Capital Management, a West Los Angeles firm specializing in individual bonds for retail investors. "They are totally flummoxed."

With Treasury yields now so low, analysts have turned cautious about Treasury debt, and many see much more value in high-quality corporate bonds.

For some fund managers, 2008 was a year of costly moves, Jacobson said.

Missteps included betting on bonds backed by commercial mortgages in the mistaken belief that such debt wouldn't get pummeled the way securities linked to subprime residential mortgages already had.

Others were hurt by their holdings of debt from Lehman Bros. and other banking firms before the financial sector's collapse in the summer and fall.

The use of borrowed money to goose returns instead magnified many funds' losses. Oppenheimer Core Bond fund, for example, lost 36% for the year in part because of leveraged positions, Jacobson said.

Junk funds suffered as investors treated lower-rated debt like hot potatoes. Oppenheimer Champion Income, an extreme case, plunged 79%.

"It was a year in which credit quality drove everything," said Mary Miller, T. Rowe Price's director of fixed income and co-manager of the firm's Tax-Free Income fund.

Money managers say Treasury funds will have a hard time repeating last year's performance now that valuations are so rich.

For short-term Treasury funds in particular, management fees can eat up all or most of the interest earned on portfolio securities. The two-year T-note currently yields less than 1%.

"You may see some investors move to directly purchase Treasury securities as a way to get around that during a 'zero interest rate' environment," said Conrad Gann, president of TrimTabs Investment Research, which tracks fund flows. (You can get information on direct purchases of Treasuries at www.treasurydirect.gov.)

The biggest problem for Treasury securities would be an economic rebound and a return of inflation, which devalues older bonds. Some managers, however, say a prolonged economic slump and deflation are more likely.

Lacy Hunt, who helps run the Wasatch-Hoisington U.S. Treasury fund, which rocketed 38% last year thanks to its long-term securities, acknowledged that lower yields make him less bullish on government obligations than he was a year ago.

But he contends those yields have further to fall. His argument: It could take years for the economy to unwind massive debt levels, and it remains to be seen whether the Federal Reserve's aggressive monetary policy and the incoming administration's expected economic measures will prove effective.

"The low in interest rates on long Treasuries is still ahead of us," he said.

During past panics such as the Great Depression, the U.S. railroad bust of the 1870s and the Japanese collapse of the 1980s, interest rates typically took 12 to 15 years to bottom out, he said. That allowed government bonds to beat stocks over 20-year spans, albeit with volatility.

Even investors wary of Treasury bonds should consider keeping some money in the sector, says Morningstar's Jacobson, because if the economy slides into deeper recession or depression, they may be the only reliable haven.

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