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Bond mutual funds soared on hope

Returns skyrocketed in many categories -- but not U.S. government bonds -- as investors felt braver in the second quarter and dumped low-yield Treasuries.

July 12, 2009|Walter Hamilton

WALTER HAMILTON AND NEW YORK — As long as you stayed away from long-term Treasury bonds, chances are you made good money in bond mutual funds in the second quarter.

Many bond-fund categories -- including high-yield, emerging-market and even investment-grade corporate debt -- produced scorching returns as suddenly nervy investors ventured back into those sectors.

Bonds were helped by the same force driving up the stock market: optimism that the worldwide recession is abating.

Investors bet that a reinvigorated global economy would help even the most troubled borrowers repay their debts. And after the big sell-off in riskier bond sectors late last year, they couldn't resist the attractive yields.

The big losers during the quarter were U.S. government bond funds, as investors abandoned low-yielding Treasuries.

That marked a sharp reversal of last year's "flight to safety" trade, in which investors huddled into Treasuries at the expense of many other sectors.

"In the second quarter, we saw almost a mirror image of the end of 2008," said Mary Miller, head of fund giant T. Rowe Price's fixed-income group.

Not that investors should expect the eye-popping returns to continue, many experts say.

As with the recent stock-market exuberance, many experts fear that the bond rally may be overdone.

At a minimum, they say, bond prices have snapped back so sharply from last year's plunge that little opportunity remains for outsize capital gains.

"Arguably, the easy money has been made," said Chris Molumphy, head of fixed income at the Franklin Templeton fund group.

Beyond that, some analysts say, riskier segments of the market could get clipped if the recession doesn't lift as rapidly as bullish investors expect. They point out that some areas, such as high-yield bonds, lagged toward the end of the quarter on renewed fears that steep job losses would weigh on consumer spending and the overall economy for a protracted period.

"This market's gotten well ahead of itself," said Dave MacEwen, head of fixed income at American Century Investments.

Even so, the second quarter was a welcome relief to bond-fund investors who endured big hits late last year.

High-yield, or junk, funds soared 18.1% in the second quarter, according to fund tracker Morningstar Inc. Emerging-market bonds rocketed 14.6%. And long-term bond funds, which hold mainly investment-grade corporate issues, jumped 10.9%.

The improving economy also was an elixir for bank-loan funds, which buy pieces of floating-rate corporate loans from banks and which fell sharply last year. They surged 16.3% in the second quarter and are up 26% this year to date, though they remain down more than 10% over the last 12 months.

At the other end of the spectrum, long-term government funds lost 8.3% and are down 15% this year, according to Morningstar.

As prices of long-term Treasuries tumbled, their yields surged, with the 30-year benchmark Treasury jumping from 3.53% at the end of March to 4.33% at the end of June, though down from a nearly one-year high of 4.76% on June 10. (On Friday, the 30-year yielded 4.19%.)

Although long-term Treasuries have gotten a boost in the last month from the latest wave of economic worries, their outlook is cloudy at best. Continuing economic improvement could spur a further exodus from the sector. And investors worry that heavy issuance of Treasuries to fund the federal government's stimulus program could push up yields on newly issued securities, thus depressing prices for existing fund holders.

Meanwhile, after an explosive rally in municipal bonds earlier in the year, the tax-exempt securities cooled off but still turned in a solid performance in the second quarter.

Long-term California muni funds gained 3.4% in the quarter, according to Morningstar.

Although most analysts say California is unlikely to default on any of its debt despite the state's economic woes and budgetary gridlock, investors in the second quarter began demanding higher yields on new issues, pushing down values of portfolios holding the older, lower-yielding securities.

Many bond-market players say they like the outlook for investment-grade corporate bonds. Some also say the prospects for long-term high-yield debt remain favorable.

High-yield corporate bonds yielded about 20 percentage points more than comparable Treasuries in December.

That differential has since been cut in half, generating huge returns. But the so-called spread is still about where it peaked in the last two recessions, suggesting there are further declines in junk yields -- and price gains -- to come over time, Molumphy said.

For investment-grade corporate bonds, the spread reached 6 percentage points over Treasuries.

It's now down to about 3 points, double or more the long-term average of 1 to 1.5 points, he said.

"You're likely to see corporate debt -- investment grade and below-investment grade -- give stocks a run for their money," said Jim Sarni, managing principal at Los Angeles investment management firm Payden & Rygel.


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