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THE BOND JUNGLEThere are still some good buys--but this is an especially tricky marketIn just a year and a half, the world has become a lot less friendly for bond-fund investors seeking income. Since 1996, the yield on 30-year Treasury bonds has fallen more than two percentage points, from 7.15% to an all-time low of just 4.75. With the economy slowing and the Federal Reserve cutting short-term interest rates, long-term Treasury yields could head even lower--perhaps 4.7% by 1999, estimates Michael R. Rosenberg, manager of international fixed-income research at Merrill Lynch & Co. Those who got into bonds early, of course, have now earned hefty capital gains. But if the past few months' gyrations on Wall Street are making you nervous about stocks and prompting you to increase the weight of bonds in your portfolio, you're in for a formidable challenge. To maximize your income, you now must accept greater credit risk, try to capture the best possible total return by moving into funds with longer maturities and more volatility, or sit tight in short-term funds until long-term rates reverse their course. We've selected a number of bond funds that have turned in solid performances in the past (table, page 134). But before you buy, you need to get a handle on the dynamics of the turbulent bond market. If you're really hungry for yield in a world of 5% Treasuries, it might be tempting to plunge into a high-yield corporate bond fund right now. With investors fleeing riskier securities in the wake of Russia's summertime debt default and the subsequent implosion of Long-Term Capital Management and other hedge funds, the spread between yields on even better-rated junk bonds and on Treasuries has soared a couple hundred basis points lately. ''It is this premium that makes the [junk] market most attractive right now,'' notes Jerry Paul, manager of the INVESCO High Yield fund. But you need both patience and an iron stomach to buy a high-yield fund today. Indeed, income investors who were already in junk funds are now seeing the flip side of this sector. Junk debt shares many characteristics with stocks, and when the equity market started to slide over the summer amid concerns over earnings and a weaker economy, high-yield bonds also gave way. The average high-yield fund lost more than 7% in the third quarter, while other bond funds were enjoying one of their best periods in years. Some popular funds were hit even harder, including the $2.7 billion Fidelity High-Income Fund, which lost 8.34%, even though it still has one of the best three-year returns (table). ''Liquidity is awful,'' complains Paul. But, of course, ''that is also what makes for opportunity.'' Given the sector's volatility, and given that it's unclear when the market's current problems will be resolved, Paul thinks investors considering high-yield funds should be prepared to let their money sit for at least three to five years. If junk funds are too risky for your taste but you think interest rates will keep falling, consider moving into higher-quality funds with longer maturities. Long-term Treasury and municipal funds, for example, are more sensitive to interest-rate changes than short-term bond funds. So their net asset value will go up more, and their total returns will gain faster as rates drop. Not surprisingly, Treasury funds with maturities in excess of 10 years were the stars during the third quarter, with a total return of about 5.3%. They looked better over the past 12 months, scoring a total return of about 14.5%. The top funds in the category achieved even higher returns. The $1.2 billion Vanguard Fixed Income Long-Term U.S. Treasury fund was up 7.7% for the third quarter and 21% over 12 months. At the same time, it has held a yield of just under 5.5%. The $325 million T.Rowe Price U.S. Treasury Long-Term fund, meanwhile, scored a third-quarter return of 7.4%, a 12-month result of 21.2%, and a yield of 5.1%. While yields appear set to fall further, that will translate into capital gains and tidy total returns, say many analysts. For investors in higher tax brackets, municipal-bond funds--especially longer-maturity portfolios in excess of 15 years--are tempting. Investors worldwide have been flocking to Treasuries, leaving muni bonds unappreciated despite their tax advantages. Thomas G. Doe, president of Municipal Market Advisors Inc., a money manager in Concord, Mass., notes that long-term muni yields are now more than 100% of those on 30-year Treasuries after averaging 80% to 90% since 1990. Figuring out whether a muni fund is right for you is easy. First, calculate a fund's tax-equivalent yield, or the yield a taxable fund would have to offer to equal that of a municipal fund. Divide the tax-free yield by 1 minus your tax bracket. For example, the average high-quality, long-term national municipal bond fund currently yields about 4.5%. That's equivalent to a 7.45% taxable yield for an investor in the top, 39.6%, federal bracket. After taxes, the only fund category that even comes close is corporate high-yield. HAVEN. While few believe rates will rise in the near term, it's important to remember that, as with any bond fund of longer maturity, an increase in interest rates can erase any income benefit you may have gained. That happened in 1994, when the Fed raised rates 2.5 percentage points and long-term muni and government bond funds lost more than 6% in total return for the year. If you're unsure how long interest rates will stay low, you might sit tight in a money-market fund. That's not a bad place to be, considering the average rate on taxable money funds is holding just below 5%. In money funds, you face little risk to your principal because shares remain stable at $1, although they aren't federally insured. Money fund assets are up 20% this year, to $1.33 trillion, as investors have sought a haven from stock market volatility. The third quarter saw the largest inflow in money funds history, with $94 billion in new money added. If interest rates do an about-face someday, investors in money funds will see returns go up even as longer-term investors take a hit. But if you want to gain yield or go for total return today, you must take some extra risks--there's no way out of it. Whether you want to concentrate on total return or grab for the attractive yields still available in muni and junk funds, there is still a case to be made for moving into bonds.
By Chip Norton in Lexington, Mass. RELATED ITEMS
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Updated Oct. 29, 1998 by bwwebmaster
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