02/12/96 BOND FUNDS CAME BACK. WILL INVESTORS?

BOND FUNDS CAME BACK. WILL INVESTORS?
Equities are getting all the attention, but bonds hold plenty of potential for gains
Suppose the bond market staged a rally and nobody came. That's what happened during 1995. Bond mutual funds scored solid double-digit total returns of 16.4%, including dividends and capital-gains distributions, more than reversing 1994's losses. That wasn't enough to keep investors in the fold, as $4 billion more flowed out of the funds than went in, a striking contrast to the $129 billion that piled into equity funds. This year, about $2.6 billion has come back to bond funds, but investors are deploying it very selectively, according to AMG Data Services, which tracks flows to funds. Most of the new money is going to corporate bond funds. Municipal bond funds are flat, and money is still exiting the government bond funds.
Perhaps some prospective investors were scared off by the 1994 bear market and didn't believe--along with most of the pros--that bonds would come roaring back. And others no doubt found the lure of a rising Dow irresistible and ran to equity funds instead. Now, having missed the tremendous capital gains, there's not much incentive to move back to bond funds. While long-term rates dropped two percentage points, short-term rates have fallen only a half percentage point. So yield-sensitive investors are sticking with money-market funds rather than exposing themselves to the volatility of longer-term bond funds.
RATING RISK. But in avoiding bond funds, investors are also forgoing the opportunity to earn capital gains that sometimes dwarf yields. It's total return, not yield, that counts in measuring your investment returns. And that's what you'll find in the BUSINESS WEEK Mutual Fund Scoreboard, which this week reports on 652 bond funds. In the tables, prepared by mutual-fund data company Morningstar Inc., we report total returns over the past one-, three- and five-year periods. We also examine yield, maturity, and a fund's performance relative to other funds, and we report on the fees and expenses. The lower the cost of the fund, the more that's left for investors--and that counts for a lot in a low-yield world.
Even total return does not tell the whole story. The Scoreboard rates funds based on their risk-adjusted total returns over the past five years and awards them anywhere from three upward-pointing arrows, meaning superior performance, to three downward-pointing arrows, for the poorest showings. This year, 39 bond funds earned top honors (table).
The list would put a big smile on the face of Michael R. Milken, the onetime junk-bond king of Wall Street. Seventeen of the funds are high-yield corporate bond funds, which invest in bonds rated below investment grade--the sort of securities he popularized in the 1980s. The theory behind junk bonds is that while there's greater risk of default, higher yields more than make up for occasional bad bonds.
Many of the top-rated tax-free funds are also high yielders. But with municipal bond funds, it's more unrated debt than low-rated debt that provides the extra juice. In the diffuse and inefficient muni market, funds with the ability to perform their own research often find creditworthy investments among smaller issuers who find it cheaper to pay a somewhat higher interest rate on their bonds than to pay for a debt rating from a ratings agency.
What's also noteworthy about the top performers list is what's not on it: a government bond fund. That's got nothing to do with the furious budget battle or the fear of a default. In fact, no government bond funds even merited two up arrows, the second-highest rating, and only a handful come up with better-than-average marks. One reason for this poor showing was that the devastating 1994 bond market hit government debt the hardest, lowering returns and raising risk ratings.
But even without 1994, government bond funds are not compelling. In the corporate or muni markets, smart credit research and good portfolio management can pay off. But in the government market, the most efficient securities market in the world, there are few inefficiencies to uncover and little value added by fund managers, especially after taking into account sales charges and ongoing fund expenses.
Before you rush to high-yield funds, remember that you're viewing them under near ideal conditions. Over the past five years, the period for the 1996 ratings, junk bonds have had the wind at their backs. Interest rates fell, allowing many issuers to refinance; corporate cash flows swelled, improving issuers' ability to service their debt; and the economy, though slow at times, grew and stayed clear of recession.
DEFENSE. Keep in mind, too, that junk funds earned high marks because their 1989-90 bear market is no longer in the the ratings period. The best example of a fund that benefits from the turn of the calendar is Dean Witter High-Yield Securities, with 24.3% average annual total return. In 1990, the fund had a horrendous -40.1% return. Its standout five-year record was launched in 1991, when the market rebounded and the fund amassed a 67.2% return. The fund also beat the competition in 1992 and 1993, but has been a laggard since.
Managers of the top-rated high-yield funds acknowledge that things have gone well since 1991 and are mindful that things might not always be so bright. ``We've turned defensive,'' says Robert J. Manning, who runs MFS High-Income A fund. Manning has upgraded the portfolio to larger, more established issuers and has moved away from subordinated to more senior debt.
But Mark E. Durbiano, who runs both Federated High-Yield Fund and Liberty High-Income Bond A Fund, takes a different view. He does not think the economy will slow enough to derail the high-yield market. In addition, he says the spread between junk-bond yields and Treasury yields is more than 4 percentage points, the widest gap since November, 1993. That yield advantage should lure new money into the market. Says Durbiano: ``The high-yield outlook for 1996 is pretty bright.''
With munis, the main worry is not interest rates or credit quality but the prospects for replacing the graduated income tax with a one-rate ``flat tax.'' Under a plan whose chief proponents include House Majority Leader Richard K. Armey (R-Tex.) and Republican Presidential hopeful Malcolm S. Forbes Jr., the tax preference for munis would end as all investment income became tax free. In that case, muni prices would fall until their yields approximated those of government and corporate bonds.
Indeed, muni bonds are already cheap relative to taxables. If the flat-tax threat subsides, munis and muni bond funds should rally. Sheila Amoroso, who runs the top-rated Franklin High Yield Tax-Free Income I, says the flat tax has no fizz because it would scrap popular deductions for interest on home mortgages and state and local taxes. ``It's like health-care reform,'' she says. ``It sounds great on the surface, but start scratching away at the details and it will become extremely unpopular.''
Thinking about investing in muni funds? Or any other bond funds for that matter? Your bond-fund search starts with the Scoreboard on page 77.
BY JEFFERY M. LADERMAN IN NEW YORK